AT1 capital/CoCo bonds: what you should know
Additional tier-1 (AT1) securities and contingent convertible capital instruments, known as CoCo bonds, absorb losses when the capital of the issuing financial institution falls below a supervisor-determined level. Here we explain everything you need to know about these hybrid securities, a key plank in bank-resolution plans, and implications for issuers and investors.
AT1 notes are a key instrument in regulators' post-crisis bail-in regime, which seeks to impose principal losses on creditors during firm-level financial distress, outside the normal bankruptcy process, and, in theory, without recourse to the public purse. Regulators hope hybrid securities and the provision of ex-ante rules to ensure orderly re-capitalization, or eventual liquidation, of a given institution can take place without triggering system-wide distress.
Total regulatory capital consists of tier-1 capital, which includes common equity tier-1 (CET1) and AT1, as well as tier-2 capital. Increased minimum capital requirements have been gradually phased in since 2014. Under Basel III, the minimum tier-1 capital requirement is 6% of risk-weighted assets (RWAs). This 6% is composed of 4.5% of CET1, plus 1.5% of AT1.
Leverage ratio improvements have been achieved through issuing AT1 instruments. AT1 instruments contain a contractual provision to convert into ordinary shares or are written-down if a bank needs to raise its capital levels, once the CET1 ratio threshold has been breached, or if authorities determine the issuer has reached the point-of-non-viability (PONV).
AT1 capital is made up of:
Subordinated and perpetual tier-1 capital instruments issued by a bank that are not included in CET1;
Share premium resulting from the issue of AT1 capital instruments;
Instruments issued by consolidated bank subsidiaries and held by third parties. The instruments must meet AT1 capital requirements criteria and not included in CET1;
Regulatory adjustments applied in the calculation of AT1.
Basel III has defined 14 criteria for instruments to qualify as AT1 instruments and therefore to be considered regulatory capital. The criteria differs from CET1 as the AT1 capital can be called five years after issue, in accordance to the guidelines. No step-ups or other incentives to redeem can be included in an AT1 capital instrument. View the minimum criteria for an instrument to be included in AT1 capital on the BIS website.
Banks such as UBS, Société Générale, Credit Suisse, Deutsche Bank and Royal Bank of Scotland issued about €91 billion ($102 billion) of additional tier-1 capital from April 2013 until early 2016.
Private banks and retail investors – before they were banned by the FSA in 2014 – have traditionally been the main buyers of AT1 instruments followed by asset management companies, hedge funds and banks. Aside from calls to standardize the regulatory treatment of bank securities, investors are still trying to understand the mechanical trigger levels, loss-absorption mechanism and discretionary triggers that should influence AT1 yields.
The Capital Requirements Directive (CRD IV) Combined Buffer Requirement (CBR) is being phased in from January 2016. A bank breaching the requirement must calculate a maximum distributable amount (MDA), determining how much it can pay out in AT1 coupons, dividends and employee compensation. The financial institution currently has discretion to determine its priority of payments when it breaches its CBR buffer. However, the ECB has indicated it would like to change EU banking law to prioritize AT1 payments.
Initially, regulation was unclear on Pillar 2 positioning relative to the CBR; an EBA proposal from December 2015, adopted by the ECB, requires positioning Pillar 2 under the CBR, effectively reducing the buffer (relative to market exceptions in 2015) protecting AT1 investors from coupon deferral.
In the first two months of the year, there were no issues of AT1 instruments amid fears Deutsche Bank would miss an April coupon payment and amid regulatory uncertainty, before the ECB's aforementioned clarifications. It is hoped that the ECB's clarifications in February – that there will be no further supervisory add-ons on bank capital in 2016, AT1 coupons should be prioritized when a bank breaches its CBR buffer, and that the Pillar 2 add-on is applicable only above minimum CET1 for the purposes of calculating the MDA, rather than the total capital metric – will thaw the freeze in the new issue market for AT1 capital.
The CBR will be fully implemented in 2019. Read more about the CRD IV, Capital Requirements Regulation (CRR) and the Bank Recovery and Resolution Directive (BRRD) on the the European Banking Authority (EBA) website.
Other classes of bail-in securities include tier-2 securities, known as gone-concern capital instruments, which can be written down to ensure common equity conforms to the regulatory minimum when a supervisor dubs the institution "failing or likely to fail".
And then there is the global effort at the Basel Committee level to promote total-loss-absorbing-capacity (TLAC) instruments – Europe's version is known as the Minimum Requirement for own funds and Eligible Liabilities (MREL) – which endure losses in the context of resolution, but which are not considered operating capital when a financial institution is a going concern.
Most tier-1 contingent convertible bonds (CoCos) are also known as additional tier-1 capital (AT1 bonds). For more information on the basics of CoCo securities, read the Bank for International Settlements primer.
'One key risk to the AT1 market is around investor confidence and how that can be impacted by regulatory scrutiny and poor execution, which in itself can lead to steep backtracking from the market by investors,' says Jeff Tannenbaum, head of DCM origination and syndicate at BAML. The relative value of AT1 securities versus other markets – particularly HY and equities – is another risk. 'There has been some AT1 investor fatigue,' agrees Chris Whitman, Deutsche Bank's head of global risk syndicate. - AT1 supply surges, while TLAC raises concerns, January 2015
Banks in Europe face a bleak choice. They can redouble cost cutting and capture the move to digital. They can also top up capital with AT1s, for which there is still a bid. But as the acute phase of the crisis now approaches and loan losses rise, banks’ fabled capital strength faces a stern test
As it presses ahead with restructuring, Deutsche will exit cash equities, cut back in rates and centre itself on a traditional corporate banking business. CEO Christian Sewing calls it the most radical transformation the bank has undertaken in decades.
The first sign that the Santander situation might not be going entirely by the book came when the Spanish bank launched a new RegS dollar 7.5% non-call five $1.2 billion additional tier-1 deal on Wednesday February 6, but did not announce the call of its outstanding €1.5 billion 6.25% AT1 notes at the same time.
Deutsche has been extremely conservative in its capital and especially liquidity buffers, ever since the panic in 2016 over its ability to service AT1 coupons. Its last published number for liquidity reserves was €268 billion, mostly in cash.
Jean Pierre Mustier is going to spend one year's salary increasing his exposure to UniCredit. In November, UniCredit announced Mustier would invest €600,000 in UniCredit shares and a further €600,000 in the bank's additional tier-1 (AT1) paper. It's not the first time that he has invested in UniCredit. On March 14, 2017, he spent no less than €4 million, again divided equally between UniCredit shares and AT1 bonds.
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Investors worry that volatility in Italian government bond prices may leave some Italian banks needing to raise capital just as the markets close to them.
EBA stress tests are past their sell by date November 2018
Stress test results are meant to reassure on bank resilience, but they no longer seem to address banks’ key risks.
AT1 contingent capital bonds are entering their second generation; issuers have begun refinancing the $200 billion asset class, but just two years ago the market looked close to collapse. What took it to near disaster? And how did it escape?
What to do when questions are being asked about the effectiveness of low-trigger CoCos? Issue higher trigger ones, of course.
Talk of exchange-traded funds offering exposure to additional tier-1 debt may not be as worrying as it sounds.
China’s latest effort to curb shadow banking involves applying Basel standards on banks: they must disclose far more of their exposure to previously unidentified counterparties. It’s good for the industry, but what does it mean for individual mainland banks?
The eventual impact of the revised capital rules will be less severe than bankers feared a year ago, even though many lament regulators’ pivot away from internal ratings.
UK banks scraped through the latest stress tests with no need to raise capital, but add a disorderly Brexit onto recession and overseas investor flight, and they could face serious trouble.
Nomura researchers estimated in October that €126 billion in tier two and additional tier-one bonds issued by EU institutions would be hit by the exclusion.
A textbook case, a long-inevitable state bailout and a brazen political fudge: Europe’s BRRD has had something of a rough ride this summer. As the region’s banks brace themselves for the capital-raising marathon that is MREL, are the new resolution regulations actually doing more harm than good?
Implementation of global standard will lead to higher tier-1 capital levels; banks well capitalized but predictions of sovereign downgrades cloud outlook.
Both AT1 and tier-2 investors lost everything when Banco Santander rescued Banco Popular, while senior bondholders were untouched. The rescue has shown that when banks in Europe get into trouble it is liquidity, not capital, that matters and that the fate of subordinated bondholders is anything but predictable.
Bank warns on AT1 coupon if €13 bln rights issue fails; move highlights importance of capital increase.
As EGM approves capital increase, lender spells out impact on regulatory capital if things go wrong.
With TLAC and minimum requirement for own funds and eligible liabilities (MREL) due to be in place by 2019, the focus on both the quantum and form of bank capital is intense.
Cryan has been telling investors in Deutsche, ever since the panic around its capacity to service AT1 coupons cratered the share price in February, that 2016 will be a peak restructuring year for the bank.
Deal shows appetite after February sell-off; bank’s tier-2 issuance could herald TLAC surge.
"The AT1 market has blown up. It is hugely expensive and self-destructive…"
When panic gripped AT1 March 2016
Investors dump Deutsche after CFO funding boast; fears spread to other bank stocks.
Until late last year, the proposed regime for resolving financial institutions through bail-inable debt – which imposes principal losses on bank securities outside the normal bankruptcy process – was not existentially questioned, aside from technical considerations. That is until February, when yields on AT1, also known as contingent convertible, or CoCo, bonds jumped by several percentage points in a few days, while the primary market firmly shut, and returns from the product were savaged.
It’s easy to blame technical factors and investors’ misunderstanding of the new AT1 market for February’s sharp sell-off across the bank sector, but investors may have a firm grasp of the fundamentals.
While investors have long accepted that bonds can be bailed-in during firm-level stress, the capital requirement determining when interest payments can be skipped on AT1 securities has now been brought into question.
Secondary yields rise above cost of equity; bankers pin hopes on lack of alternatives.
A recent memo from Deutsche Bank CEO John Cryan to employees, from which most observers concentrated on his assertion that Deutsche remained 'rock solid’ amid concerns that it might not be able to meet coupon payments on its AT1 debt, sought to address what Deutsche might be in the longer term.
Flight to AT1 from high yield expected; tier 2 needed to mitigate ALAC impact.
AIB’s return to the subordinated debt markets in mid-November last year was six times over-subscribed. Two weeks later, it successfully placed a debut additional tier-1 bond as part of a wider capital reorganization – including redemption and conversion of state preference shares – in readiness for the reprivatization.
This controversial bail-in was triggered by a €1.4 billion capital shortfall at Novo Banco that was identified in November’s European Central Bank (ECB) stress tests. It needs to be understood in the light of preceding events. Firstly, the rescue of regional Banif and its subsequent sale to Banco Santander. This follows a €1.1 billion injection of funds into Banif by the state in January 2013 and its €400 million participation in a contingent convertible bond issue by the failed bank.
UBS's group treasurer Carlo Pellerani says UBS started issuing AT1 in February 2015. 'The first thing we did was to organically accumulate common equity tier 1. We want to be the best-capitalized bank in our peer group. AT1 will become a permanent feature in our regular funding plans.'
The minimum requirement for own funds and eligible liabilities (MREL) is due to become effective in January but its final determination could still be years away.
Prospects of a TLAC announcement coincided with many European banks rushing to fund at the end of September, eager to get ahead of any developments. In the last week of the month, UBS issued $4.3 billion in its first holding company issuance, BNP Paribas issued $1 billion tier-2 notes and Société Générale issued its first AT1 trade.
Awards for Excellence 2015: July 2015
Best global debt capital markets houseBarclays is a market leader in AT1 innovation and tier-2 Cocos, as well as transforming legacy capital into new CRD IV-compliant capital. Key deals over the period include Standard Chartered’s $2 billion AT1 and, in insurance, the €500 million perpetual for SACE.
Best emerging markets debt houseOver the awards period, HSBC was the top arranger of global EM bond deals, according to Dealogic, with 520 transactions and a 4.86% market share. Key deals include Banco do Brasil’s $2.5 billion AT1 deal (the first Basel III-compliant issue in Brazil).
Best debt house in Latin AmericaCiti was bookrunner on innovative transactions such as Banco do Brasil’s June 2014, Basel III-compliant capital offering. This deal was the largest AT1 offering from an EM issuer and the largest single-tranche offering from a LatAm FIG issuer – and one of the largest post-crisis Basel-complaint trades.
Being the only bank in the UAE owned outright by the government of Abu Dhabi, one of the richest states in the world, Al Hilal Bank’s additional tier-1 perpetual sukuk last year understandably attracted plenty of investor interest.
Chris Bowie, partner and portfolio manager at TwentyFour Asset Management, says he is buying "new corporate bond issues at yields lower than he normally would" too. He gives the example of buying into the dollar tranches of UBS’s recent additional tier-1 capital bond – the first to be sold from its new holding company – both of which were priced at issue to yield over 7%. Without QE, those yields would undoubtedly have been higher.
The AT1 market, which had been the story in FIG DCM all year, ended 2014 with a $5.7 billion bang thanks to Industrial and Commercial Bank of China’s triple-currency trade.
Concern for providers of equity to banks spills over to providers of AT1 capital, such as contingent convertibles subject to equity conversion or permanent write-down. Investors increasingly see the big risk on buying these instruments being not in banks converting into equity on trigger breaches but on non-payment of coupons, which might become subject to the same influences as regulators have imposed on restricted dividend payout policies.
Bankers are looking past Sunday's publication of the stress-test results and the TLAC requirements that will follow to a substantial change in how banks fund in the capital markets and maybe even new forms of senior debt.
"For a while, we’ve been saying to the regulator that the loss-absorbing trigger for AT1 should be part of the Swedish finish," says Jan Erik Back, chief financial officer at SEB. "We’re under no pressure to raise AT1, but it would be beneficial to be given some clarity about the trigger levels so that we can take advantage of the window of opportunity that is now open to issue at fantastic spreads."
A November rush to market is anticipated, but there are signs of a flight to quality by investors.
HSBC saw no apparent need to delay its nervously awaited three-tranche, dual-currency issue of $5.7 billion of AT1 securities. The bonds, which convert into shares on any breach of 7% on HSBC's CRD IV common equity tier 1 ratio and on which coupons are fully discretionary and can be turned off, drew strong demand as the AT1 market seemed to recover its poise after the summer sell-off. HSBC priced the bonds just two days before news broke of the FHFA settlement, which looks like a regular run of business item. Welcome to the banking industry in 2014.
CoCos have been a big hit with investors looking to buy highly rated paper that offers some yield in a low-return environment. In what can be seen as an impressive sleight of hand, bank issuers of CoCos have been able to focus the debate over valuation of the deals on minor structural differences in what are relatively complex hybrid bonds. This has served to mask the fact that banks are selling CoCo deals with yields far below their own cost of capital, despite the plausible view that the trades should be valued as close in form to equity, albeit with some debt-like features. The cost of capital for major banks is conservatively viewed as a minimum of 10% nowadays, and is arguably closer to 12% for most firms. But CoCo deals have been sold with yields to call dates that were under 5% this year, as issuing banks found willing buyers among both institutional and retail investors.
Bail-in risks have not been priced into the markets for European bank bonds where issuers have been busily selling subordinated debt, new forms of AT1 capital and senior debt this year. The real risk on those AT1 deals is coupon deferral, which could come much sooner than any breach of capital ratio triggers, if loan losses were to mount.
Awards for Excellence 2014: July 2014
In addition to the bank’s own recent landmark AT1 trade it was involved in, among others, the first replicable AT1 structure for SG, the first tier 2 CoCo to receive equity treatment from S&P for Crédit Agricole and Lloyds’ landmark £5 billion ECN to AT1 exchange. "This is the stuff we like," says Hakan Wohlin, global head of debt origination at Deutsche Bank in London. "We were viewed as a senior funding house but we are now known as a capital house. We have been actively engaged with regulators and investor education on bank capital."
Bank capital trades have been the overriding theme in FIG this year and this is another sector in which HSBC has played its part. It was co-structurer on Italy’s first CRD IV-compliant AT1 deal for UniCredit and brought the first tier-2 transaction from a Spanish bank in 2014 for BBVA.
Danske’s high and above-target CET1 and total capital ratios – which stood at 14.7% and 21.4% respectively at the end of December – supported its successful €750 million additional tier 1 (AT1) transaction in March, which generated demand of €13 billion.
Deutsche Bank’s own €3.5 billion AT1 deal – just outside the period of consideration for these awards – attracted €25 billion in orders and is expected to herald a flood of such deals from German banks over the next year.
Some analysts suggest Deutsche could have improved its total capital ratio by selling much more AT1 capital than its current €5 billion programme. However, sources say that Deutsche was pushed into an early announcement of the equity raising ahead of its AGM by mixed feedback from investors on the €3 billion AT1 deal it had been roadshowing who wanted it to bolster its pure equity cushion.
Banks around the world have been issuing new Basle III-compliant tier 1 and 2 capital instruments, and a growing investor base has developed alongside this fast-growing asset class. Latin American banks, however, have largely remained interested observers. To date, the region has seen Basle III-compliant perpetual tier 1 (AT1) transactions only from Banco do Brasil.
Lloyds LME highlights potential risks to investors of early regulatory calls in the booming AT1 market.
Overwhelming demand for a string of bank AT1 deals shows the extent of investors’ desperation for yield as much as their faith in the restored health of the banking sector. As more new investors accept these deals, hopes grow that a €150 billion AT1 market might emerge quickly now. But terms have tightened far and fast and AT1 can be volatile.
The New York Fed chose the day before its public meeting to discuss amendments to the supplementary leverage ratio to publish a new call for big US banks to retain a portion of their earnings in a special capital account (SCA) that can be tapped to replenish their core capital instantaneously, and automatically, when it is diminished due to losses. Looked at another way, the SCA seems designed to fulfil much the same function as the contingent convertible or regulatory AT1 deals that have been so popular recently from European banks in replenishing their capital in stress conditions.
Two types of bank issuer have taken advantage in the primary market. Banks from the periphery have sold senior unsecured bonds. Banks from the core have issued AT1, the new contingent capital deals that suffer either temporary write-down or conversion into equity if issuers breach triggers on their common equity tier 1 ratios. Both types of deal have met heavy over-subscription in recent weeks and the kind of inflated order books reminiscent more of tech IPOs at the height of the internet boom.
If any evidence were needed that the chase for yield is alive and well and headed further down the capital structure it came with Crédit Agricole’s debut AT1 trade in late January.
Last October Banco Popular paid an 11.5% coupon on an €500 million additional tier 1 capital trade. Although those interest payments are tax-deductible and proceeds counted as capital, that’s still a hefty coupon on any liability for analysts to compute into a bank’s business model.
€31 billion AT1 needs to be issued by end-2014; Benchmark inclusion key to future appetite.
"New rules like required leverage ratios may also prompt banks to raise new forms of capital such as additional tier 1 that could be a cheaper way to deleverage rather than shedding assets at a discount. All the recent AT1 deals from banks have been well received and we expect the AT1 market to grow substantially over the next years. There is a pool of approximately €150 billion in existing capital that needs to be replaced over the next two to three years," says Paul Young, head of debt capital markets, EMEA, at Citi.
Why the UK - and European - bank-deleveraging cycle has much further to go, following George Osborne's call for the Bank of England to review leverage ratios.
Société Générale successfully completed only the second additional tier 1 capital deal from a European bank designed to comply with new capital requirement regulations and the first since the European Banking Authority clarified technical standards at the end of July.
Last month investors in European banks were still absorbing the news that Barclays will plug a capital shortfall identified by the Bank of England by completing a £5.8 billion ($9 billion) rights issue, issuing a £2 billion additional tier 1 contingent convertible, and shrinking assets by £65 billion to £80 billion so as to achieve a leverage ratio of 3.1% by mid-2014.
Awards for Excellence 2013: July 2013
The ability of the Irish government this January to find buyers for €1 billion of Bank of Ireland contingent convertibles that were first issued to the government as part of its recapitalization in 2011 was an important positive both for the bank itself and for Ireland. Investors submitted bids totalling €5 billion for the high-trigger bonds, clearly attracted by the high coupons amid a yield drought.
BBVA’s additional tier 1 capital raising generated an astonishing €9 billion of orders, prompting bankers to proclaim it the opening of a big new market. But the staggering array and complexity of conversion triggers contained in the deal has set off alarm bells among investors.
For all the rhetoric about the importance of international cooperation in banking oversight, a lack of trust, regulatory fragmentation and a complex pipeline of divergent policy measures, particularly at the national level, are preventing the creation of a workable cross-border bank resolution system, observers warn.
When faced with the impending death of effectively risk-free bank credit, investors in senior unsecured bank debt are oscillating between the five stages of grief: denial, anger, bargaining, depression and, eventually – regulators, at least, hope – acceptance.
Basel III, Dodd-Frank and market pressures are forcing banks to bolster their tier 1 and loss-absorbing capital levels on their balance sheets, a process that is under way but far from complete. There are few palatable options on the capital-raising menu.
Investors and regulators will like its latest plan to pay part of bankers’ compensation in a new form of contingent convertible.
UniCredit taps Asian appetite; BoI CoCo attracts €5 billion
The ramifications of selling contingent convertible bonds (CoCos) to retail buyers could be brutally illustrated by the bailout of Cyprus’s banking sector, while ties with Russia complicate strategy.
After the past few tumultuous months that Barclays has had, the bank may not be considered in the fittest of states to show other banks a way forward. But the novel structure and success of its sale of $3 billion of contingent convertible notes, or CoCo bonds, in November could provide a very handy blueprint for other banks to use.
Barclays, as it is now constituted, still has some staunch supporters. Ian Gordon, analyst at Investec dismisses “scaremongering over a perceived capital shortfall” that led Barclays to issue a $3 billion, 10-year contingent convertible paying 7.625% when its capital position was already “rock solid”.
"If we can get investors interested in CoCos it will be very interesting," observed Barclays chairman Sir David Walker at the same meeting. "The principle is perfectly attractive." The UK bank first announced its intention to pay bonuses in contingent convertible notes at the beginning of January 2011 under then chief executive Bob Diamond. Since then, however, the market in CoCos has stalled.
Bankers harbour fears that local branches of foreign banks will be forced to hold costly regulatory capital, given concerns over the convertibility of certain capital instruments under Basel III. These branches might find difficulties in issuing convertible debt in the host jurisdiction if there is no market for their equity – since the parent bank generally owns 100% of that equity, unlike Santander and HSBC’s subsidiarity business model.
Awards for Excellence 2012: July 2012
Credit Suisse excelled with innovative offerings, such as the hybrid for Swiss Re featuring a contingent conversion to equity clause as well as an ‘at market price’ discretionary stock settlement.
The Portuguese government announced on Monday that it planned to inject up to €6.65 billion into three banks: BPI, BCP and state-owned CGD. The former two also plan on carrying out separate rights issues by September. While this is expected to bring core tier capital ratios at the three banks up to 10% by the end of the year, it’s also set to have an substantial dilutive effect on the banks. Nomura analysts expect the earnings dilution to be around 85% at BPI, and more than 100% for BCP. There is also concern over the banks’ ability to repay the contingent convertibles, given the weak earnings outlook at Portuguese banks.
Allianz has also shown itself to be an innovative issuer. Last year, it negotiated a privately placed €500 million contingent convertible sold to Nippon Life. Conversion of the debt into shares would be triggered by a decline in its Solvency II ratio to the point where the company would need additional equity. Theissing says: "We intend to run with a strong Solvency II ratio both in absolute terms and relative to our peers and this gave us additional cost-efficient, non-dilutive protection."
Tier 2 CoCo struggles; CS taps Swiss-franc investor base
Until the exact nature of the rules is clear, investors will continue to find hybrid bank capital a challenge.
News that the EBA has sanctioned the issue of contingent convertible (CoCo) bonds by European banks to meet their core tier 1 capital requirements was confirmed yesterday as the authority announced that banks still need to find €115 billion of capital by June next year. The EBA will treat CoCos as additional hybrid tier 1 capital. The trigger point will be 7% of core tier 1.
Banks that have issued CoCos so far (Lloyds, Rabobank, Credit Suisse and Bank of Cyprus) have set trigger levels based on the banks’ Basle III CET1 ratios. Haldane proposes that rather than using CET1 to trigger conversion the structures should use simpler market-based measures, which can be calculated "on the back of an envelope by a competent clerk".
The main challenge banks face in selling these notes, apart from investors’ unwillingness to buy debt from any European issuers at the moment, is the complexity of the pricing methodology for contingent capital. According to Nomura’s investor survey, even more sophisticated investors have not used a fundamental approach when evaluating CoCos.
The Basle Committee’s decision in June to disallow the use of contingent convertible (CoCo) bonds to meet capital buffer requirements for systemically important financial institutions (SIFIs) came as a nasty surprise to many banks that had invested time and resources in the new instruments.
Awards for Excellence 2011July 2011
Bank of Cyprus was intimately involved in one of the most important capital market stories of the year – the development of the contingent convertible bond market.
Strong demand from conventional investors; regulatory support, hunger for yield, a simple structure and clever timing.
"The proposal to bail-in senior creditors on non-viability of a bank has been the talk of the market ever since it was mooted last year and remains as unpalatable to investors now as it was then. Discussions centre on whether all senior unsecured issuance post-2013 should carry a bail-in provision or whether an entirely new class of senior bail-inable debt should be created. Existing issuance before 2013 will be grandfathered but the likelihood of the sector getting away with no bail-in language at all is diminishing by the day."
Any debate about loss absorption and risk sharing inevitably gravitates towards hybrid capital, particularly contingent convertibles – the market upstart that has been catapulted into the spotlight by the interest that the regulators have shown in its suitability for bank regulatory capital under Basle III.
Bank of England executive director of financial stability Andrew Haldane’s recent comments on trigger mechanisms for contingent convertible (coco) notes have been met with a chilly response from banks.
Strong demand from conventional investors promises bright future for new-style bank capital; Regulatory support, hunger for yield, a simple structure, and clever timing are keys to success.
It is one of the eternal unknowns of the bond market, a riddle wrapped inside a mystery inside an enigma: who is going to buy contingent capital notes?
The air is thick with gossip, surprisingly, about contingent convertibles. The buzz is that Barclays has been sounding out the markets for a deal, that UBS and Credit Suisse are preparing to issue. The host bank, too, is apparently keen to do one. Euromoney is confused.
Ever since Lloyds and Rabobank issued the only two contingent convertible deals to take place so far (in late 2009 and earlier this year) activity in the market has been confined to a great deal of talk and not much else. But with the Swiss Federal Council’s announcement in early October of its acceptance of Cocos as part of a bank’s capital requirement, interest in the instruments has reached a new level. Credit Suisse will surely issue one.
When the Basle Committee on banking supervision proposed new minimum capital requirements in September of 7% total common equity against bank assets and 10.5% total capital, they left open the possibility of imposing higher surcharges on systemically significant or so-called too-big-to-fail banks.
Regulators will be delighted to see debt investors accept capital risk; other bank issuers remain unconvinced.
Just how regulators will treat the new vogue of hybrid capital, so-called contingent convertible instruments, or CoCos, seen as a panacea to the hybrid capital weakness, isn’t completely clear in the proposals.
One likely new trend is the ushering in of a new form of bank capital: contingent convertible securities. It first emerged late last year on the initiative of regulators keen to revamp the hybrid capital markets, which failed to absorb losses when banks became distressed in 2008. Lloyds Banking Group’s bond exchange in November, which enabled existing tier 2 debt to be exchanged for new debt that converted into equity if the bank’s core tier 1 ratio fell below 5%, broke the ice for more transactions of this genre in 2010. "Lots of banks are currently working on structures like that which have that contingent-type feature and can be put into tier 1 debt immediately,’’ says a London-based syndicate banker. He adds that they will not necessarily resemble Lloyds Banking Group’s equity capital notes but will achieve the same goal as these by bolstering bank balance sheets.
Lloyds Banking Group ushered in this new asset class last month with its £7.5 billion exchange of existing hybrid securities into contingent convertible bonds, popularly dubbed CoCo bonds. The regulator-backed creation of a new form of bank capital is designed to boost Lloyds core capital ratio to 8.9% from 6.3%, because the CoCos convert into common equity precisely in the event that Lloyds tier 1 ratio falls below 5%, a key metric in the FSA’s stress test for UK banks.
Lloyds Banking Group ushered in this new asset class last month with its £7.5 billion exchange of existing hybrid securities into contingent convertible bonds, popularly dubbed CoCo bonds. The regulator-backed creation of a new form of bank capital is designed to boost Lloyd’s core capital ratio to 8.9% from 6.3%, because the CoCos convert into common equity precisely in the event that Lloyd’s tier 1 ratio falls below 5%, a key metric in the FSA’s stress test for UK banks.
In July Greek bank EFG priced a €300 million non-innovative tier 1 contingent share-settled perpetual non-call five. It might not be the catchiest description of a deal but the features are friendly to both the regulator and investors. It also came at a very agreeable price for EFG. "What that means," says Lake at HSBC, which acted on the deal, "is that if it’s not called in year five, the investor has the right to force the bank to sell stock at the then market clearing levels to satisfy principal at par." He adds: "The bet the investor is making is that the bank will be there in five years – it will have a stock price. There is no optionality built in because there is no strike price now in which to exercise that stock. But what it does provide is a higher certainty of getting par back."
Geithner still talks hopefully of the government providing capital assistance in the form of contingent equity – convertible preferred shares – as a bridge for those banks that will inevitably be found by any stringent stress test to be inadequately capitalized for the likely default rates that lie ahead. This bridge will support them until they can receive increased private capital – "institutions will have an opportunity to turn first to private sources of capital". One is tempted to ask for some of what he is smoking.
Awards for excellence 2001July 2001
The Tyco deal also introduced a new structure to the US market - the zero-coupon contingent conversion. This sets a floor for investors to convert the debt into equity. To be fair, it's not a wholly new structure - Lehman had first used it in a deal for Bank Austria back in 1999 - but it was the first time it had been tried in the US.
"It's not the usual Merrill LYONS convertible," explains Jones. "Those are zero-coupon deals. This one was what we call a LYONS CoCo - or contingent conversion."
The index of exposure, in the days when loans were loans, was the capital ratio. A bank's capital base was the buttress of its assets and its hedge against the risk of lending. Now that balance sheets are swapped and unswapped, and now that the balance sheet itself is but the surface trace of an enormous well of contingent assets and liabilities, that's no longer true. The leading American banks now shelter assets worth two or even three times the value of their balance sheets --all of them highly liquid and subject to the increasing volatility of the traded markets. So now there's only one protection against the chill uncertainties today's exposures contain, and that's information.