The CoCo is a new financial instrument enabling banks to raise capital – and convert it into equity during future crises. Joanne Hart finds out its potential to be one of the most significant financial products, however, relies upon the right support and investor appetite.

Since the onset of the financial crisis, regulators, policy-makers and bankers have grappled with what went wrong and how to reduce the chances of it happening again.

Much of the work has centred on bank capital, specifically the creation of more robust structures that strengthen banks' financial positions and make them less dependent on government cash when times are hard.

Enter contingent convertible capital. At its most basic, this is debt capital raised by banks that can be converted to equity (or written down) if certain triggers are breached. Advocates believe it can provide meaningful balance sheet support, on the assumption that it is cheaper to issue than equity but could turn into equity if required. At the point of issue, investors would receive a higher coupon than what straightforward fixed-income products offer, while issuers could avoid raising large amounts of expensive and dilutive stock.

Introducing the CoCo

The instruments, affectionately known as CoCos, have been under debate almost since the financial crisis erupted, but so far only two banks have dipped a toe in the water and neither has done so in quite the manner envisaged for the future.

In the autumn of 2009, UK bank Lloyds raised £7bn ($11.1bn) of enhanced capital notes (ECNs) – they offered an above-average coupon, qualified as lower Tier 2 capital and convert into equity if Lloyds' Tier 1 capital ratio falls below 5%. So far, so CoCo-like. But the notes were issued to replace existing securities rather than create fresh capital so investors' options were limited.

The only other issuer to date is Rabobank, which last March raised €1.25bn through the issue of contingent capital instruments. AAA rated Rabobank raised new money, but the structure of its deal differed from that widely anticipated for CoCos in two important respects. First, the host instrument ranked as senior debt. Second, if Rabobank's equity capital ratio falls below 7%, the bonds do not convert into equity (as Rabobank is a mutual) but are written down by 75%. Rabobank's notes paid a coupon of 6.875%, some three percentage points higher than an average bond from the Dutch bank, but the group still thought the exercise worthwhile.

"We raised the money to enhance our creditworthiness and in anticipation of regulatory requirements we think we will have to satisfy," says Michael Gower, head of long-term funding at Rabobank.

Swiss benchmark

Nearly a year later, the Basel Committee on Banking Supervision and independent regulators are still deliberating how CoCos will work. But the Swiss National Bank took the debate to a new level last autumn when it said systemically important Swiss banks (UBS and Credit Suisse) would have to hold total capital equivalent to 19% of risk-weighted assets on their balance sheets, including 9% in the form of contingent convertible capital. The banks have until 2013 to raise this debt, but it is estimated that Credit Suisse will have to raise about SFr36bn ($37.3bn) of CoCos, while UBS will have to raise approximately SFr27bn of CoCos over the next two years.

Even in Switzerland, the figures are far from clear, with some analysts believing Credit Suisse alone will have to raise nearly SFr60bn. Globally, this lack of clarity is even more marked. Standard & Poor's suggests up to $1000bn of CoCos may need to be issued over the next five to 10 years. Other observers are less extreme, but most concur that banks may be required to raise several hundred billion dollars of CoCos in the next decade.

Which begs two fundamental questions: who will buy them and at what price?

David Lyon, managing director, global finance, Barclays Capital

David Lyon, managing director, global finance, Barclays Capital

"It is difficult to assess the market when regulators are not in agreement and there is widespread debate about what the international architecture of financial regulation should look like," says David Lyon, managing director of global finance at Barclays Capital.

"However, if it emerges that CoCos are required by regulators, investors will take a hard look at them. And if high-quality banks issue them, a decent yield could well prove attractive to potential investors," he adds.

Some banks, such as UBS (perhaps not surprisingly) and JPMorgan have undertaken specific investor surveys to gauge appetite for CoCos and find out more about principal concerns.

UBS surveyed investors who it expects will be buyers of CoCos and the results were more positive than the bank expected. The key questions raised were whether they were actually able to hold paper that converted to equity and whether they could hold paper that might be permanently written down.

"In the short term, until the product is an established asset class, the appeal or otherwise of CoCo instruments will focus on the credit-worthiness of the issuer, their capital strength, their systemic importance and the price at which the securities are issued," says Prasad Gollakota, head of European capital solutions at UBS.

"Attitudes have somewhat developed since 12 months ago. Early on, around the time of the Lloyds ECN transaction, investors were very resistant to these instruments, due to the perceived loss upon breach of the pre-specified certain trigger. Now, larger institutional investors are preparing themselves for what is coming."

Other bankers echo this view. "We see some very large institutional investors looking at contingent capital as a once-in-a-decade opportunity to step in and capture premium at the beginning of a new market. There has been a step change in the past few months. Some investors are even looking at setting up dedicated funds," says Simon McGeary, head of new products at Citi.

Trigger points

JPMorgan's survey of 189 top investment institutions, which was conducted at the end of last year, indicated that investors would be more inclined to buy CoCos if the trigger points were crystal clear from the outset. "Subjective triggers are much less favoured, as they introduce an even greater element of uncertainty, given that the triggering of such options would ultimately be at the discretion of the authorities in a situation of distress," says David Marks, chairman of the financial institutions group (FIG) debt capital markets group at JPMorgan in London.

Under the Swiss plan, known as 'the Swiss finish', because the capital requirements are substantially higher than those currently proposed by Basel, there would be two points at which CoCos would be triggered: if Tier 1 capital ratios fell below 7%, and if they fell below 5%. Many believe this may be a sensible way forward.

"Having two triggers provides two different risk/reward profiles. The 7% level is the first line of defence. If this were breached, the Tier 1 capital ratio would be bolstered by an injection of fresh equity so, if the 5% level were then subsequently breached, it would effectively be at a far greater level of distress. We envisage hedge funds, equity-income investors and high-yield funds buying the 7% CoCos, while the 5% layer might appeal to traditional asset managers," says Mr McGeary.

Unanswered questions

Basel is expected to provide further clarification of how contingent convertible capital might work in the middle of the year. As yet, even basic questions remain unanswered, such as whether capital would necessarily be converted to equity at a certain point or whether it could be written down, like the Rabobank transaction. Some banks and regulators are even pushing for a write-down/write-up structure, where capital would be written down at a certain point but could then be written up if and when the issuing bank returned to health.

According to JPMorgan: "Respondents expressed a dislike for permanent write-down language." This could, however, depend on the strength of the issuer. Rabobank saw €2bn of demand for its €1.25bn transaction and the nature of investors took the bank by surprise.

"We were expecting equity-type investors but we also had plenty of traditional fixed-income institutions because they already knew us so well. They wanted to know why we were doing it and we said we were hedging the unthinkable," says Mr Gower.

For quoted banks, however, CoCos that convert to equity give rise to one key concern – whether traditional fixed-income managers could even buy such instruments or whether they would need to change existing mandates to do so: fixed-income investors cannot normally own shares.

Like many of those involved in the CoCo debate, Frank Heitmann, head of Europe, the Middle East and Africa convertible origination at Credit Suisse, believes a rating of these instruments would help to ensure the broadest demand from a wide range of asset managers. But he suggests agencies are making progress in that direction, provided certain criteria are met.

"S&P will rate CoCos with objective triggers such as regulatory capital ratios, but instruments where the conversion or write-down is at the issuer's or regulator's discretion will not be rateable. Moody's is likely to review its methodology for rating instruments with triggers tied to capital ratios, once there is more clarity on the future regulatory framework," says Mr Heitmann.

Other issues give rise to concern too. Shyam Parekh, head of European FIG capital markets at Morgan Stanley, says there is a lot of discussion about the best way to structure these products.

"Issuers and investors are asking questions such as: Do they convert to equity? Do they write down? If they write down, do they write up again? If they convert to shares, what will non-quoted banks do? What about pre-emption rights in some jurisdictions? And if the triggering of a CoCo becomes a big event in itself, would this precipitate the very situation it is intended to avoid?" he asks.

Pitching the right price

There is also the crucial matter of price. From the issuers' point of view, CoCos need to be priced in a way that makes them more cost-effective than equity. "Given our expectation that CoCos will be priced with single-digit yields, we believe that CoCos will allow banks to reduce the cost of the increasing capital requirements," says Mr Heitmann.

Some market-followers believe that, while single-digit yields could be achieved by well-known names, investors may be far more demanding when it comes to subscribing to CoCos from lesser banks, ultimately driving a consolidation through the industry.

"For lower-rated banks, they will probably need to pay 12% to 13% yields for such a structure, which is clearly unfeasible. So they will either have to look at alternatives or consider changes to their business model if such structures become compulsory," says Mr Gower.

JPMorgan's Mr Marks is more robust. "Investors have every incentive to talk the price up, but yields in the low teens are overly expensive for most banks," he says. "Lower Tier 2 does offer a tax shield so there is some mitigation, but the Lloyds deal has performed since launch, rallying from about 11% to 9.7%."

Lloyds' ECNs may not be completely comparable to CoCos but they are actively traded and the original deal size was sufficiently large as to make them a decent benchmark for future issuance.

"[The] Lloyds and Rabobank deals both trade with a spread about 300 basis points wider than the underlying host instrument. But they are both closer to lower trigger CoCos. If the price on a higher trigger instrument were prohibitive, then it might make rational economic sense for some banks to issue equity instead," says Mr Parekh.

As regulators wrestle with the whole issue of bank capital, uncertainty persists. But David Benson, vice-chairman for risk and regulatory affairs at Nomura, suggests that employees may be given the option – or not – of receiving CoCos.

"This would be consistent with regulators' desire to control risk behaviour," says Mr Benson. "Mature pension funds with high-income requirements may be natural buyers too. CoCos would be higher yielding than equity although they don't have the same potential upside."

In common with others, Mr Benson is concerned about the impact of hedge funds on this embryonic market. "They are natural buyers of this product but they would short the underlying equity, and the nearer an issuing bank got to a trigger point, the more they would need to short, precipitating a possible death spiral," he says.

This is one of the many issues that needs to be addressed over the coming months. Even now, there is a considerable amount of disagreement among regulators and among potential issuers about the merits or dangers of CoCos.

Instrument of the future?

Many bankers are increasingly of the view, however, that CoCos will be one of the most significant products of the next decade, providing the right conditions are created and maintained. Encouraging investors to participate in the market may require engagement from the rating agencies and comprehensive education from issuers, lead managers and regulators.

Mandates may need to be changed and indices may also need to be amended, as many institutions will only subscribe in any meaningful sense if CoCos are included in bond indices.

Much work needs to be done but most market participants suggest there has been a sea change in sentiment over the past few months. Whether this means investors are ready to snap up CoCos worth several hundred billion dollars is another question.

"Overall, we think the market for contingent type products will develop, but that it will take time and the structure needs to be sensible. A big global issuer, well known to the credit market and considered systemically important, should have fewer problems getting a deal done, with the right trigger and pricing," says UBS's Mr Gollakota.

In other words, CoCos may well work for the larger banks. But for second- and third-tier players, the challenge may be significantly greater.

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