The CoCo Conundrum

In a recently published BIS paper a nice overview is given of contingent convertibe capital (“CoCo”). But the study contains a riddle as well.

CoCos are defined as hybrid capital that absorbs losses when the capital of the bank falls below a certain threshold. This threshold is called the point of non viability (PONV). Once the capital drops below this threshold, the CoCo is either converted to equity or its principal is written down. Either way, the bank’s capital receives a boost while at the same time its debt is reduced.

The paper explains that CoCos have two defining characteristics: the loss absorption mechanism and the trigger that activates this mechanism. As mentioned above, the loss absorption takes place by a conversion of debt to equity or by a principal writedown. Triggers are either mechanical or supervisors’ discretion. In the first case, the absorption mechanism is triggered as soon as the bank’s capital ratio falls below a predefined level. Book-value triggers are commonly defined as Common Equity Tier 1 capital (CET1) divided by Risk Weighted Assets (RWA). Market-based triggers are defined with the help of the bank’s market capitalization. The benefit of market based triggers is that they are independent from accounting valuations and permanently available. However, their disadvantage is that they may lead to stock price manipulation. Short selling the stock may be a profitable strategy when the bank is close to the point of non-viability, especially when anticipating the dilution of the share price after the mechanical debt-to-equity conversion.

Supervisors’ discretion means that the absorption mechanism is activated as soon as the bank’s supervisor believes that the bank is at the point of non viability and the activation is needed to prevent insolvency.

CoCos and Basel III

High-trigger CoCos may quality as additional tier 1 capital (issued perpetual debt), while low-trigger CoCos may qualify as tier 2 capital. In order to qualify, these CoCos need to have the additional discretionary trigger.

The minimum capital-based trigger for qualification as additional tier 1 capital is a 5.125% CET1/RWA ratio. The share of CoCos that have the additional discretionary trigger as well as a mechanical trigger at 5.125% (CET1/RWA) has increased since banks have embarked on the implementation of Basel III.

The tax deductibility of the interest payments makes CoCos an attractive capital instrument for the issuing banks and their investors. However, in some jurisdictions the tax treatment of CoCos is still uncertain.

Liquidity issues in case of a partial principal writedown

CoCos that use the principal writedown absorption mechanism rather than conversion to equity may have a dangerous side-effect due to the introduction of liquidity risk. If the principal drawdown is not 100% but only partial, the bank needs to pay out a cash compensation to CoCo investors once the CoCo has been activated. The liquidity risk is that this cash payout happens at a time during which the bank is in distress.

The pricing riddle

The BIS study publishes some data on CoCo pricing levels. The spread on the yield-to-maturity of a sample of CoCos to non-CoCo subordinated debt is shown below.

YTM spread of CoCos compared to non-CoCo subordinated debt (source: BIS)

YTM spread of CoCos compared to non-CoCo subordinated debt (source: BIS)

 

We can conclude from the graph that the yield spreads are pretty large, overall 350 basis points for high trigger CoCos. This signals that investors require a substantial mark-up on their coupon rate in order to assume the risk that the CoCo is triggered. The high yield spread can also be caused by the uncertainty that still surrounds CoCos. The same uncertainly has led to initial reluctance of credit rating agencies to rate CoCos. The rating process is especially hindered by problems to assess the discretionary triggers.

On the left hand side of the graph, we see that the low trigger CoCos carry a lower spread than high trigger CoCos. This is a logical outcome since the risk that the loss absorption mechanism is triggered, and investor value is reduced or even entirely wiped out, needs to be priced in the coupon rate. Of course, this activation risk is higher for high trigger CoCos and hence the higher yield spread.

The riddle is why the subset of principal writedown CoCos (right hand side of the graph) does not show this trend. The authors of the BIS paper explain this as follows [PONV = Point of Non-Viability]:

One possible explanation for that apparent pricing anomaly is that most of the low-trigger PWD CoCos in our sample have a PONV clause, whereas the majority of the high-trigger PWD CoCos do not. As discussed above, the PONV clause raises the probability that the loss absorption mechanism will be activated, which causes investors to demand a higher premium for holding CoCos with a PONV clause.

Apparently, the small sample of the BIS study does not allow for an effective control of the additional discretionary trigger factor.

For me, this raises a new question: do low-trigger principal writedown CoCos typically contain an additional supervisory trigger or is this a specific characteristic of the BIS sample? Both low-trigger and high-trigger CoCos need the additional supervisory trigger in order to qualify for tier 1 or tier 2 capital.

(1) S. Advjiev, A. Kartasheva, B. Bogdanova, CoCos: a primer, BIS Quarterly Review September 2013

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Over Folpmers
Financial Risk Management consultant, manager van een FRM consulting department, bijzonder hoogleraar FRM

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