Contingent convertible (CoCo) bonds seem to be flavour of the month with regulators, but issuers and investors alike may need some convincing. Writer Philip Alexander
When bankers read the consultative proposals published by the Bank for International Settlements (BIS) on December 17, 2009, some began to think that, in an attempt to prevent a repeat of the 2008 credit crunch, the world's financial regulators might be about to create a new crisis. The aim of increasing both the quantity and quality of capital, to avoid the need for massive government assistance to the financial sector in the future, is understandable.
But the BIS proposals contain a string of measures likely to force banks to deleverage further, or raise fresh capital. On the capital side, the regulators' forum is proposing a tighter definition of core Tier 1 (to exclude deferred tax assets and minority interests) and raising the pressure to hold a higher proportion of core Tier 1 in the total capital structure.
The BIS is also proposing a counter-cyclical capital buffer, which would build up during boom years, giving greater room to run down during slower economic growth. Taken altogether, this set of proposals has the potential to generate a new tidal wave of bank capital needs across the global banking sector - and not just among those banks that fared badly during the crisis.
"If you compare year-end average core Tier 1 of European banks at the end of 2009 to what it was two years before, it has grown from 6.4% to 8.8%. If you look at the total capital ratios, including hybrids and subordinated debt, it has grown from about 11% to 14%. So overall capital ratios have increased by about a quarter, but it seems like the pressure could well be equally great ahead, both for harmed and for unharmed banks," says David Aubin, co-head of the European financial institutions group (FIG) at BNP Paribas in Paris.
Vinod Vasan, head of FIG debt capital markets at UBS
Hybrids under fire
The treatment of hybrid capital looks especially fierce. The BIS has gone beyond the EU capital requirements directive (CRD), due to come into force at the start of 2011, by suggesting that innovative Tier 1 hybrids - which include a step-up coupon if the bond is not called at the first opportunity - would not count towards Tier 1 capital.
And the cut-off dates for grandfathering hybrids issued before the new regulations come into force is unclear - the BIS implied that any hybrid issued after its consultation paper of December 17 might fall under the eventual new guidelines.
As a result, FIG bankers generally expect to see something of a hiatus in hybrid issuance until the BIS completes its consultation and publishes its final report in July 2010. In particular, the minimum and maximum proportions of capital to be held in each category have not yet been specified by the BIS, leaving issuers with uncertainty about how much hybrid capital to hold in the overall mix.
And yet, banks still have to decide what to do with hybrids maturing or reaching their call dates in the first half of 2010, or more generally if they have urgent capital needs. Moreover, spreads have tightened sharply in the second half of 2009, showing that there are investors back in the market willing to take a higher risk for a higher return.
Genuine loss absorption
The contingent convertible (CoCo) deals launched in the UK by Lloyds banking group in November 2009, and Yorkshire Building Society a month later on its merger with Chelsea Building Society, might be the model to tick all possible regulatory boxes.
In both cases, the new bonds issued were lower Tier 2 capital, on which coupons cannot normally be deferred unless the bank ceases to be a going concern. But these two new bonds, also known as enhanced capital notes (ECNs), would convert into core Tier 1 capital if the bank's total core Tier 1 ratio fell below 5%.
This would provide an automatic, stabilising capital boost if future losses drove the capital cushion down too far. In this way, it also helps banks to avoid immediate injections of equity capital to meet the stress-testing scenarios increasingly used by regulators and credit rating agencies to determine appropriate capital levels.
The UK Financial Services Authority (FSA) welcomed these deals, providing an insight into the spirit of supervisory thinking. That insight may be more helpful than seeking to issue hybrids that comply with the uncertain letter of new regulation. Paul Sharma, director of prudential policy at the FSA, explains the official concern that traditional hybrid capital cannot carry out its stated function of permanently absorbing losses for a bank that remains solvent.
"Even with a genuine perpetual bond, if the bank ran into difficulty it could stop paying the coupon, but only temporarily until it recovered. As soon as it had raised new capital, a lot of the economic value of the new capital would go to restore the coupons on the perpetual, which also makes it more difficult for the bank to raise new capital," says Mr Sharma.
Shyam Parekh, head of FIG capital markets Europe at Morgan Stanley
Permanent dilution
By contrast, pure equity capital can be permanently diluted, which Mr Sharma calls the "touchstone" of genuine loss absorption. To obtain regulatory dispensation under the new EU CRD as fully loss-absorbing capital, a hybrid bond would need to use one of two characteristics.
"Either, should you run into difficulty it could convert into ordinary share capital; or, there is a permanent write-down in the capital amount of the instrument. In both of those circumstances, the instrument would be capable of absorbing losses on a going-concern basis," says Mr Sharma.
Understandably, bankers believe regulatory encouragement may therefore drive the development of the CoCo market, just as a previous generation of Basel accords stimulated the evolution of hybrid capital. Prasad Gollakota, co-head of European Capital Solutions and Liability Management at UBS, says the UK leads the way, underpinned by the FSA's published core Tier 1 capital requirements for stress tests. Other regulators are also assessing the regulatory viability of a CoCo-type structure, and the BIS committee will clearly play a role in their thinking.
Counter-cyclical buffer
Internationally, CoCos could be used to form part of the counter-cyclical capital buffer advocated by the BIS. Shyam Parekh, head of FIG capital markets Europe at Morgan Stanley, says a more stringent outcome from the BIS consultation may be more likely to stimulate CoCos as part of a compromise arrangement, especially given the desire to avoid choking off lending to the real economy.
"Most banks are saying they have already increased their core capital substantially, so they do not really need a buffer on top. But if regulators ask for a contingent capital buffer, or if they allow for common equity to be replaced with contingent capital in return for tightening the definition of core capital, then many issuers would look at issuing contingent capital, if it can be done at a reasonable cost," says Mr Parekh.
Niche or mainstream?
For that cost to be reasonable, however, the investor base will need to grow accustomed to the peculiarities of a new instrument. Both the Lloyds and Yorkshire deals were exchanges where CoCos replaced existing subordinated debt - and in the case of Lloyds, that debt was not paying coupons.
However, Vinod Vasan, head of FIG debt capital markets at UBS, who worked as a structuring advisor on the Lloyds deal, says it is wrong to assume that little can be deduced from the transaction about the wider prospects for a CoCo market. Although the new bonds were issued as an exchange, it was still possible to discern the shape of a new investor base.
"As this was a par-for-par bond exchange with a set waterfall priority, much of the trading ahead of the deal represented new money coming in to receive the ECNs, while life insurers and others sold their positions," says Mr Vasan.
He suggests that CoCos can make a further contribution by helping to diversify the investor base for bank capital away from the usual subordinated debt buyers. The instrument might also appeal to retail investors, because the conversion trigger is entirely transparent, especially with the intensified capital reporting requirements that the BIS is likely to usher in.
But many life insurers - a key investor base allowing conventional subordinated debt to be issued in large volumes - are focused on finding assets that match their liability profile. This favours fixed income instruments, and some insurers or the fund managers that they mandate may not even be legally able to hold a bond that could be converted into equity.
Mr Parekh suggests a CoCo might therefore work best as a hybrid that writes down part of its principal if the trigger core Tier 1 level is breached, so automatically deleveraging the bank. This might appeal more to insurance or pension fund investors, as it would remain a pure debt instrument.
Investor hurdles
Regular convertible bonds have traditionally been the domain for hedge fund and multi-asset long-only investors, or fixed income investors with a less constrained mandate who may hold a small proportion of convertibles to help beat their benchmark. But there are hurdles even for this investor base, says Mr Aubin.
"Many equity-linked investors like to hedge out some of the risks to focus on the equity optionality which they can manage. An ECN with a core Tier 1 level as the conversion trigger brings in a digital risk, which can barely be hedged or modelled. That is likely to leave many investors on the sidelines," he says.
Nonetheless, as hedge funds rebuild their liquidity lines, Mr Aubin believes their appetite for complex instruments will return, helping to kick-start a CoCo market: "Probably not in the first half of 2010, but after that, who knows? It could be a market in 2011," he says.
Rolf Petermann, head of FIG coverage (Germany and Austria) at Société Générale Corporate and Investment Banking (SGCIB)
Mutually convenient
Matthew Lindsey-Clark, managing director in the financial services team at Lexicon Partners, says CoCos are likely to behave very differently in the market from a regular convertible. The traditional convertible behaves less like a bond and more in line with equity the higher the share price rises, as investors buy the convertible as a means to access the rising share price. A CoCo would behave more like fixed income as the share price rises, because higher bank earnings make the probability of conversion more remote.
Mr Lindsey-Clark, who advised Chelsea on the Yorkshire deal and ECN, believes CoCos may be highly relevant for the mutual and co-operative banking sectors both in the UK and in continental Europe. These institutions do not have the option of issuing straight core Tier 1 capital to non-members through a rights issue like a listed bank. Profit-participating deferred shares, as issued by West Bromwich Building Society, permanently reduce the membership's share of the mutual's profits and are difficult for issuers and investors to price.
Consequently, a CoCo - which might never need to be converted - could be a better alternative, especially if conditions remain difficult in the regular subordinated debt market. The largest UK mutual, Nationwide, has a steady schedule of maturing hybrids, and so could be a trailblazer.
Core still key
In the case of listed banks, it remains to be seen whether, if a bank's capital ratio approaches the 5% trigger point, the possibility of CoCo conversion actually reassures financial markets or depositors. Large investors might seek to hedge impending conversion by shorting the share price, which could complicate matters if the bank found it needed any capital on top of the converted CoCo.
International agreement
Rolf Petermann, head of FIG coverage (Germany and Austria) at Société Générale Corporate and Investment Banking (SGCIB), says it will also be essential for regulators internationally to agree common features such as the capital ratio conversion trigger point for CoCos. Otherwise, it will be much more difficult to develop a deep and broad enough market for these already rather complex instruments.
"At the moment, depending on the client situation and regulatory recognition, I would still be much more likely to advise clients to issue subordinated mandatory convertibles, an instrument that is familiar to investors and essentially provides a delayed capital increase at a set time in the future," says Mr Petermann. This extra capital can then be used as a cushion for any losses that might materialise, or preferably for fresh balance sheet expansion if the overall outlook and balance sheet strength has improved instead.
Cost question
Until a critical mass of deals comes to market, it will remain unclear whether CoCos are cost-effective relative to each bank's capital needs. In the case of Lloyds and Yorkshire Building Society, contingent capital was appropriate because there was poor visibility over the future performance of their assets - legacy HBOS portfolios for Lloyds, and legacy Chelsea buy-to-let portfolios for the Yorkshire.
In practice, however, FIG bankers expect that the largest investor base and best pricing will exist for banks that have more predictable portfolios and are unlikely ever to need to convert the bond. But as one banker points out, investors will have to adapt and intensify their analysis of traditional hybrid instruments in any case, because pressure from regulators means hybrid coupon deferrals or missed call dates are likely to remain more frequent.
"The traditional hybrid investor base wanted an unwritten guarantee that coupons would be paid and bonds called at the first possible date. They just wanted fixed income with a few basis points of yield pick-up. That is not realistic in the new world, and all big bank capital investors will need to link up their equity and fixed income platforms," he says.
