No sooner had bond market participants learned of Credit Suisse’s successful completion of a buffer capital notes deal widely marketed to investors outside the US than expectations grew that more offerings would follow quickly in the weeks ahead. Suddenly estimates for the eventual supply in a new and unproven bank capital market that has stuttered along with a handful of outstandings for the past 15 months start at $500 billion and go up from there.
The $2 billion Credit Suisse transaction generated demand of $22 billion, with orders coming in from 500 separate accounts ranging from private banks to hedge funds, specialist convertible funds and conventional fixed-income investors.
These buyers were all clamouring to take the chance that the bank would not, through the 30-year life of the five-year call host bonds, see its Basle III common equity tier 1 ratio fall below 7%, thus triggering conversion of the notes into common equity at what would no doubt be a low point for bank share prices.
So, after a number of false starts since the debt exchange by Lloyds Banking Group at the end of 2009 that marked the emergence of such instruments, it seems that the takeoff point has finally been passed for contingent capital.
"We’ve spent over 12 months talking to institutional investors on Cocos," recalls Chris Tuffey, co-head of credit capital markets at Credit Suisse. "There have been a lot of nay-sayers who have suggested that the universe of potential buyers is too small and the market capacity is constrained. I think the irrational pessimism, in itself, made some investors nervous."
What finally convinced investors to make the leap? It helps that Credit Suisse’s lead domestic regulator, Finma, has played a pioneering role in requiring the banks under its charge to make contingent bonds that convert into equity in a downturn into a large part of their capital structures.
Credit Suisse must have SFr12 billion ($12.7 billion) of high-trigger contingent capital – debt that converts into equity if its common equity tier 1 ratio falls below 7% – in place by the end of 2019, as well as additional low-trigger notes that convert if the ratio falls to 5%.
Other banks that have been working on contingent capital structures in recent months have struggled to convince investors that they offer an acceptable reward for the risk, and regulators that they offer a true buffer.
So Barclays, for example, while gaining Financial Services Authority blessing for its plan to pay bonuses to its most senior risk-taking bankers – its so-called code employees – from 2011 that vest over a three-year period and will be withheld if tier 1 common equity falls below 7%, has struggled for months to negotiate with the regulator and core investors a bond offering designed to flip into equity on such a trigger and to flip back into debt if the equity ratio recovers. "Our intention is still to go to a fully marketed tradeable instrument," says a Barclays source.
Even more important than regulatory support for Credit Suisse’s breakthrough was the perennial core pitch to yield-hungry investors in a market where credit spreads are narrowing: rather buy the subordinated instrument of a low-risk issuer than the senior debt of a high-risk one.
"We believe this speaks to investor demand for the credit quality of a strong issuer such as Credit Suisse Group"
David Mathers, Credit Suisse
The timing was clever. The private placement showed two things: first that demand for this form of capital was so strong that an initial placement could take out half of the potential supply of high-trigger notes at a single stroke. Second, it showed both the hunger for yield and the trend to improvement in the bank’s spreads.
The tier 1 capital notes sold to Qatar Holdings and Olayan Group will not come into existence before October 2013, on the first call date for existing tier 1 capital notes the bank sold in 2008. The coupons on those existing hybrids are 11% on the dollar portion and 10% on the Swiss franc.
Under the agreed exchange, the two investors will accept 9.5% on the dollar portion of the new buffer capital notes and 9% on the Swiss franc. By agreeing the exchange so far in advance, Credit Suisse highlights improvements in the market price for its debt and at the same time avoids paying any cost of carry on issuing in advance. That’s neat.
The private placement nicely paved the way for a public deal structured to appeal to as broad a base of buyers as possible. On this, the tier 2 host bonds are less risky than the tier 1 buffer capital notes that were privately placed. While Qatar Holdings and Olayan will take perpetual notes with coupons that are cancellable in the event of regulatory capital triggers being breached, buyers of the public deal receive 30-year notes with coupons that remain payable.
Mathers is at pains to describe the circumstances in which the buffer capital notes would convert into equity as "unlikely and remote". But not so long ago that description might also have applied to the notion of UBS requiring public rescue.
The regulatory minimum common equity tier one ratio (CET1) will be 10%. If that is breached, dividends may be suspended, as may all coupons that can be delayed or cancelled, such as those on tier one securities. But if the bank then were to breach the 7% CET1 ratio, the equity conversion would take it back to the regulatory minimum 10%, leaving investors with equity in a going concern at what should be a recovery point.
Conversion would be at the higher of $20 or SFr20 a share – so roughly 50% of the prevailing share price in mid-February – or the volume-weighted average price over the five trading days before conversion.
Unlike the new issue of contingent capital for unlisted Dutch cooperative Rabobank last year, which mandates a simple write-down of principal, or the prospective Barclays structure that might restrict investors’ ability to sell while awaiting hoped for reconversion into senior debt, holders of converted Credit Suisse BCNs would be able to sell the equity or ride it to recovery.
In the event of a further downward spiral for the bank, a second tranche of low-strike buffer capital notes will eventually be sold that convert into equity if the regulatory common equity tier 1 ratio falls below 5%. Tuffey discreetly declines to discuss the likely macroeconomic or bank-specific stresses in which this might occur beyond that they would be "absolutely catastrophic".
The key for the wider market is that through a combination of simple structuring, persistence with potential investors and deft market timing, Credit Suisse has unearthed a legion of potential buyers for contingent convertibles.
Investor distribution of BCN deal
Source: Credit Suisse
The bank conducted Asian and European roadshows. Early demand came from high-net-worth individuals in Asia via private bank networks. "These investors have been significant buyers for callable tier one paper," says Tuffey. "On Cocos, they have determined that the return is adequate to compensate them for the risk that the trigger is hit. More conventional institutional investors focused on the tier-two bond host structure. Some of the big global funds that participate across the capital structure, were also involved. And then many retail-oriented bond funds in Europe decided that their mandates were broad enough to allow some allocation to an instrument that might, at some point, convert into equity."
That breadth of demand offers a wake-up call to other potential issuers that have been dithering over deal structures and removes the first-mover disadvantage of launching into a new market with few traded comparables.
"Nowadays, there are even dedicated contingent convertible funds looking for product," says Tuffey.
In the matey world of debt capital markets, Tuffey fielded almost as many messages from his peers on rival syndicate desks, all hoping to do deals for their own banks and for a wide universe of other bank issuers, as from Credit Suisse’s own sales force as the deal proceeded. Their betting was that, with the tier-one private placement setting a cap of 9.5%, the yield on the public deal might be anywhere between 8.5% and 8.125%.
peak demand for Credit Suisse’s deal
The deal priced at a yield of 7.875% and quickly traded up to 103, with Credit Suisse and its co-leads making markets in large size.
When will the next contingent convertible deals follow? A debt capital markets source at a rival bank says: "Before this deal I would have said ‘eventually’ or ‘before too much longer’. Now I’m thinking next week, or the week after."
Credit Suisse: Basle and FSB announcements are not death knell for CoCo market