CONTINGENT CONVERTIBLES' - THE WORLD OF COCOS JAN DE SPIEGELEER & WIM SCHOUTENS - REACFIN
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February 2014
'Contingent Convertibles'
The World of CoCos
Jan De Spiegeleer & Wim Schoutens
February 2014
Reacfin's 10th anniversary event
Outline 2
Introduction (Wim) Quantitative Side of CoCos (Wim)
n Contingent Capital n Anatomy of CoCos
n The life of a CoCo n Modelling CoCos
n Pro’s and con’s
n Issuers and investors
Regulatory Aspects (Jan) Risk Management of CoCos (Jan)
n Basel III and CRD4 n New instruments, new risks.
n Bail in vs CoCos n The Death-Spiral effect
n Extension Risk
Introduction 3 A Contingent Convertible (CoCo) bond is a debt instrument that converts into equity or writes down as soon as the banks gets into a life threatening situation. Conversion/write down happens via a predefined trigger mechanism: e.g. Common Equity Tier-1 (CET1) falling below 7% and is often accompanied with a regulatory trigger. For CoCos with a conversion feature, this creates dilution for existing shareholders, but protects potentially taxpayers.
What is a CoCo ? 4 In the aftermath of the financial crisis Contingent Capital solutions were proposed to strengthen bank’s Additional Tier 1 (AT1) and Tier 2 (T2) capital levels. CoCos are such AT1 or T2 instruments and are situated in the hybrids area of the balance sheet in between equity and traditional debt. Under the new EU Capital Requirements Directive (CRD4), all new AT1 capital needs to have CoCo features.
What is a CoCo ? 5 n CoCos are issued as bonds, but the more the bank is in trouble, the more CoCos start behaving as equity. n How to model it: as fixed income or as equity ? n How to threat it : as a child or and adult ?
What is a CoCo ? 6
n CoCos are issued as bonds, but the more the bank is in trouble, the more CoCos
start behaving as equity.
n How to model it: as fixed income or as equity ?
n How to threat it : as a child or and adult ?
“Like teenagers, they spend many hours in their bedrooms,
suspiciously quiet, you never knowing what they are up to,
and then suddenly there’s an outburst of sound and fury,
the cause of which you never understand.
Hybrid instruments and teenagers are both to be treated
with love and understanding.”
Paul WilmottThe Life of a CoCo 7
Regulatory
Trigger
Bondholder becomes Shareholder
C C DISTRESS or
Bond is (partially) written down
Core Tier 1
Trigger
ISSUE C C C C C C C C C REDEMPTION
Coupon Payments
NEW ISSUECoCos Payoff Profile 8
Payoff Profile – small probability of an extreme high loss
Probability
Gain LossIntroduction: CoCos Nature 9 Difference with convertible bonds • High coupons • Unlimited Downside (No Bond Floor) • Limited Upside (Bond Ceiling) • Negative convexity
Major Outstanding European CoCos (Feb/2014) 10
10CoCo
Yield
Breakdown
11
• Interest component: in the present low interest rate
environment rather small.
• Liquidity component: CoCos are new asset class with
only relative liquidity and a still a lot of regulatory
uncertainty and model uncertainty.
• Extension risk component: Most CocCs are callable
bonds . However most of the time no step-up is present/
allowed.
• Coupon cancellation risk: For some CoCos (T1)
coupons are cancellable at the discretion of the issuer/
regulator. They are typically non cumulative.
• Conversion component: compensates for the event that
the CoCo bond is converted into equities or reduced in
value.
• Optional Conversion component: reduces because of
the right of the investor to participate in the positive
performance of the underlying shares (CoCoCo only).CoCo
Yield
Breakdown
12
• Interest component: in the present low interest rate
environment rather small. 150 - 300 bp
• Liquidity component: CoCos are new asset class with
only relative liquidity and a still a lot of regulatory
uncertainty and model uncertainty.
50 -100 bp
• Extension risk component: Most CocCs are callable
bonds . However most of the time no step-up is present/
allowed. 25 - 50 bp
• Coupon cancellation risk: For some CoCos (T1)
coupons are cancellable at the discretion of the issuer/
regulator. They are typically non cumulative.
• Conversion component: compensates for the event that
the CoCo bond is converted into equities or reduced in
value. 400 - 500 bp
• Optional Conversion component: reduces because of
the right of the investor to participate in the positive
performance of the underlying shares (CoCoCo only).CoCo
Yield
Breakdown
13
On average, CoCos offer a 4 times spread pickup over senior, or over 400 basis
points in absolute terms.Who
buys
CoCos
?
14
n Asset Managers:
Have the expertise and have previously been
exposed to hybrid instruments (pre-2008). Have
large existing holdings in T1-T2 products. There
have been some recent launches of CoCo
funds.
n Hedge Funds
Have more risk-appetite and have the
experience to hedge to some extend the
unwanted risks away.
n Insurance Industry
Solvency II favors short dated, high rated debt.
This is opposite to what CoCos stand for.
However the extra yield is often attractive.
n Employees
Some investment banks (Barcap, CS) pay
CoCo bonuses to their top-management.
14CoCo Issuance 15
European Contingent Convertible Issuance
70
CoCo Bonds
60
CoCo Bonds (Write Down)
CoCo Bonds (Equity Conversion)
USD (bn) 50
40
30
20
10
0
Dec−09 Dec−10 Jan−12 Jan−13 Feb−14
TCoCo Issuance : Lloyds (December 2009) 16
European Contingent Convertible Issuance
70
CoCo Bonds
60
CoCo Bonds (Write Down)
CoCo Bonds (Equity Conversion)
50
USD (bn) 40
30
20
10
0
Dec−09 Dec−10 Jan−12 Jan−13 Feb−14
T
“…its worth a try…”
Mervin King
Governor Bank of EnglandCoCo Issuance : “Swiss Finish” 17
European Contingent Convertible Issuance
70
CoCo Bonds
60
CoCo Bonds (Write Down)
CoCo Bonds (Equity Conversion)
50
USD (bn)
40
30
20
10
0
Dec−09 Dec−10 Jan−12 Jan−13 Feb−14
T
“…A finishing school (or charm school) is a private school for girls that emphasizes
training in cultural and social activities. The name reflects that it follows on from ordinary
school and is intended to complete the educational experience, with and emphasis on
etiquette….”
CoCos are the finishing touch in the strengthening of the capital of the
Swiss banks.CoCo Issuance : Lloyds (December 2009) 18
European Contingent Convertible Issuance
70
CoCo Bonds
60
CoCo Bonds (Write Down)
CoCo Bonds (Equity Conversion)
50
USD (bn) 40
30
20
10
0
Dec−09 Dec−10 Jan−12 Jan−13 Feb−14
T
Write Down CoCo bonds
outnumber Equity Conversion CoCosCoCos Pros and Cons 19
Can they save the banking system ?
þ extra buffer
þ clear upfront conditions
þ no taxpayer money at stake
þ coco-bonus
þ ...
Caveats :
n if held by financial institutions,
no reduction of systemic risk
n death spiral
n can work too slow
n ...Regulatory Aspects 20
Avoiding the use of tax payers’ money 21
BASEL
III
Avoiding the use of tax
payers’ money
Make bank Make bank
failure less failure less
disruptive likely
Make banks Make bank
Resolution debt loss
Authority Living Wills less volatile
absorbing
Ring Central Contingent Bail-In
Dodd Frank Fencing Clearing Capital CapitalBasel III world : CoCo Friendly 22
n Regulatory Capital needs to be loss absorbing
n CoCo Bonds are allowed in the capital structure
– 2% Tier 2
– 1.5% Additional Tier 1
► 5.125% Trigger
► Discretionary Coupons
► Perpetual with no incentive to redeem early
► Callable after 5 year
► Subordinated
► Regulatory trigger (Point-of non-viability)
n Leverage Ratio Calculations
n ECB’s comprehensive assessment (2014)CoCos and the ECB’s comprehensive assessment (2014) 23
Risk Assessment
• Liquidity Asset Quality
• Funding Review
• Leverage
Stress test
• Baseline Scenario
• Adverse ScenarioCoCos and the ECB’s comprehensive assessment (2014) 24
Risk Assessment
• Liquidity Asset Quality
• Funding Review
• Leverage
Stress test
• Baseline Scenario (8% CET1)
• Adverse Scenario (5.5% CET1)
CoCos can be used to offset the capital shortfall. The caveat is here the fact that the AT1
CoCo bonds have their trigger set at 5.125%. They therefore cannot be put at work in the
stress tests.Basel III world : CoCo Friendly
Issuance of Contingent Capital in Europe
35
Additonal Tier 1
30 Tier 2
Issue Size ($ bn) 25
20
15
10
5
0
Jan10 Jan11 Jan12 Jan13 Dec13
T
The main focus of the European banks since Q3-2013
was on the issuance of AT1-CoCo Bonds 25Basel III world : CoCo Un-Friendly 26
n CoCo Bonds are not-allowed to deal with the extra capital imposed on globally
systematic important institutions (G-Sibs)Will CoCo’s Trigger ? 27
Counter Cyclical Buffer
9.50 Capital Conservation
9.00 Buffer
8.50
8.00 Core Equity
7.50
7.00
6.50
6.00
5.50
5.00
4.50
4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00Will CoCo’s Trigger ? 28
Counter Cyclical Buffer
9.50 Capital Conservation
9.00 Buffer
8.50
8.00 Core Equity
7.50 7% CoCo Trigger will recapitalize
7.00 the bank automatically
6.50
6.00
5.50
5.00
4.50
4.00 Bank is insolvent in Basel III
3.50
3.00 (CET1Will CoCo’s Trigger ? 29
Counter Cyclical Buffer
9.50 Capital Conservation
9.00 Buffer
8.50
8.00 Core Equity
7.50 7% CoCo Trigger will recapitalize
7.00 the bank automatically
6.50
6.00
5.50
5.00
4.50
4.00
3.50 As soon as the bank “eats” into
3.00 its buffers, it will no longer
2.50 have the initiative : coupon payments,
2.00 bonus payments are under regulatory scrutiny
1.50
1.00
0.50
0.00 Banks could strengthen their capital base before
a trigger occurs !Quantitative Aspects of CoCos 30
CoCos Anatomy All CoCos are different 31
• Maturity (> 5y) • Loss Absorbing Mechanism
• Coupon (7-10 % ?) § Conversion
• Trigger Event • Conversion Price = Issue Price (Lloyds)
CP = S0
§ Accounting: e.g. CET1CoCo
Pricing
32
CoCos Pricing Methodologies
n Credit Model (Rule of Thumb)
n Equity Derivatives Model (Barrier Option Pricing)
- EXPECTED YIELD CALCULATION
n Others (academic/hard to calibrate):
(8-10% Coupons)
- firm value valuation
-(PROXY) HEDGING and RISK
- jump models MANAGEMENT
- stochastic vol models (death spiral effect)
-… - ISSUE SIZE DETERMINATION
(free-float vs short sales)
- RELATIVE PRICING (investment
strategies) … 32CoCo
Pricing
33
Rule of Thumb Pricing for a CDS:
Credit Spread = Expected Loss x Default Intensity
cs = (1 – RCDS) x λdefault
Example 1: The Rabobank cds spread (senior) is 65bp. For an expected recovery rate of 40%,
this corresponds to an estimate of λdefault of 1.09% = 0.65%/(1-0.4).
Rule of Thumb Pricing for a CoCo Spread:
CoCo spread = (1 – RCoCo) x λtrigger
Example : When will the Rabobank CoCo trigger: λtrigger = ?
On the trigger event, there is a haircut of 75%. The recovery is hence 25% (RCoCo = 25%).
Suppose, the CoCo spread of the Rabobank CoCo is 304 bp.
λtrigger = 3.04% / (1-0.25)= 4.05%. Note that conversion happens before default : λtrigger > λdefault
RABOBANK CREDIT SPREADS ONE YEAR DEFAULT/TRIGGER PROBABILITY RABOBANK
450 5.5
5
400
4.5
350
4
Default Prob
300 λTrigger =4.05%
c=304 Trigger Probability
Default Prob (%)
3.5
SENIOR (40% Recovery)
bps
250
COCO (25% RECOVERY) 3
200 2.5
2
150
1.5
100
1
c=65 λDefault =1.09%
50
01−Jan−2013 19−May−2013 05−Oct−2013 31−Dec−2013 0.5
T 01−Jan−2013 19−May−2013 05−Oct−2013 31−Dec−2013
21−Feb−2014
TCoCo
Pricing
:
Equity
Deriva?ves
Approach
34
Barclays CoCo Bond − US06740L8C27
20
18
16
S ∗ /S ( %)
14
12
10
Non−Callable CoCo [S1]
Callable 10Yr NC5 (priced till call date)
8
01−Jan−2013 01−Apr−2013 01−Jul−2013 30−Dec−2013
T
34Risk Management of CoCos 35
Past Performance doesn’t tell us anything… 36
160
150 CoCo (Total Return)
MSCI
JPM Gvt Bond Index
140 JP Morgan High Yield Index
130
120
110
100
90
80
Dec−10 Jun−11 Dec−11 Jun−12 Dec−12 Jun−13 Feb−14Past Performance doesn’t tell us anything… 37
Period:12−31−2010 :14−Feb−2014
14
12
Annualized Return (%)
10
CoCo (Total Return)
8 MSCI
JPM Gvt Bond Index
JP Morgan High Yield Index
6
4
2
0 2 4 6 8 10 12 14
Realized Volatility (%)
Volatility
Tail RiskDeath Spiral Risk 38
The existence of the death-spiral puts a cap on the
maximum amount of CoCos a bank can issue.Death Spiral Risk Death Spiral Risk increases over time
Combing with convertible bonds ? No ! 40
n Convertible bonds have a positive convexity in normal market circumstances
∂2 P
2
>0
∂S
n In distressed market circumstances, the opposite is trueExtension Risk 41
n The increased issuance of AT1 CoCo bonds emphasizes the extension risk
Issuance of Contingent Capital in Europe
35
Additonal Tier 1
30 Tier 2
25
Issue Size ($ bn)
20
15
10
5
0
Jan10 Jan11 Jan12 Jan13 Dec13
TExtension Risk 42
n The increased issuance of AT1 CoCo bonds emphasizes the extension risk
n Companies do not necessarily call back their bonds on the first call date
n Example : Deutsche Bank did not call back a bond in Dec 2008. The market price of
the bond dropped 10%Extension Risk 43
Extending a bond creates no longer a
reputational issue
Source : barclays capitalExtension Risk 44
n CoCo bonds cannot be considered to expire on the first call date
n The extension risk has been embedded into our two approaches :
– Credit Derivatives Method
– Equity Derivatives Method
n New Concepts
– Expected Maturity Date
– Expected Extension Period
– Call Probability
–…
n Explanation is available for downloading :
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2390344Extension Risk : Example 45
Implied Trigger level for Barclays
Barclays CoCo Bond − US06740L8C27
20
18 Implied Trigger
Levels should not be different ?
16 S*Callable > S*Non-Callable
S ∗ /S ( %)
14 The higher trigger level materializes
the extension risk. The bond does
not expire on the first call date
12
10
Non−Callable CoCo [S1]
Callable 10Yr NC5 (priced till call date)
8
01−Jan−2013 01−Apr−2013 01−Jul−2013 30−Dec−2013
TExtension Risk : Example 46
Implied Trigger level for Barclays
Barclays CoCo Bond − US06740L8C27
20
Adjusting the model for a possible
18 Extension risk creates a better fit
between S*Callable and S*Non-Callable
for the CoCo Bond
16
S ∗ /S ( %)
14
12
Non−Callable CoCo [S1]
10 Callable 10Yr NC5 [S2]
Callable 10Yr NC5 (with Extension Risk) [S3]
8
01−Jan−2013 01−Apr−2013 01−Jul−2013 30−Dec−2013
TQuestions ? 47
n Jan De Spiegeleer
jan.spiegeleer@mac.com
n Wim Schoutens (KU Leuven)
wim.schoutens@kuleuven.be48
References
[1] De Spiegeleer, J. and Schoutens W. (2011) Contingent Convertible Coco-Notes: Structuring & Pricing. EuromoneyBooks.
[2] De Spiegeleer, J. and Schoutens, W. (2012) Pricing Contingent Convertibles: A Derivatives Approach. Journal of Derivatives,
Vol. 20, No. 2: pp. 27-36.
[3] De Spiegeleer, J., Schoutens, W. (2012). Steering a bank around a death spiral: Multiple Trigger CoCos. Wilmott Magazine,
2012 (59), 62-69.
[4] De Spiegeleer, J., Schoutens, W. (2013) Multiple Trigger CoCos: Contingent debt without death-spiral risk. Financial
Markets, Institution and Instruments Journal 22 (2).
[5] Corcuera, J. M., De Spiegeleer, J., Ferreiro-Castilla, A., Kyprianou, A.E, Madan, D., Schoutens, W. (2013), Pricing of
Contingent Convertibles under Smile Conform Models. Journal of Credit Risk, Journal of Credit Risk 9(3), 121–140.
[6] Maes, S. and Schoutens, W. (2012) Contingent Capital: An In-Depth Discussion, Economic Notes, vol. 41, no. 1/22, pp. 59–
79
[7] De Spiegeleer, J., Forys, M., Schoutens, W. (2012). Contingent Convertibles. In: Encyclopedia of Debt Finance Euromoney
Books.
[8] De Spiegeleer, J., Van Hulle, C., Schoutens, W. (2011). Cracking the coco pricing conundrum, July issue, 20-21 pp:
CreditFlux.
[9] Madan, D.B. and Schoutens, W. (2011) Conic coconuts: the pricing of contingent capital notes using conic finance ,
Mathematics and Financial Economics, Volume 4, Issue 2, pp 87-106.
[10] Campolongo, F., De Spiegeleer, J., Di Girolamo, F. and Schoutens W. (2012) Contingent Conversion Convertible Bond:
New avenue to raise bank capital. Working paper.
[11] De Spiegeleer, J., Dhaene, J. and Schoutens, W. (2013). Swiss Re’s $750m solvency trigger coco is much riskier than it
seems. Credit Flux. Technical Analysis, April 2013.
[12] Corcuera, J.M., De Spiegeleer, J., Fajardo, J., Jönsson, H., Schoutens W. and Valdivia, A. (2014) Close form pricing
formulas for CoCa CoCos, Journal of Banking and Finance, to appear.
[13] De Spiegeleer, J., Van Hulle, C., Schoutens, W. (2014). The Handbook of Hybrid Securities: Convertible Bonds, CoCo
Bonds and Bail-In, The Wiley Finance Series.APPENDIX 49
CoCos Anatomy (APPENDIX) 50
European Contingent Convertible Issuance
70
CoCo Bonds
60
CoCo Bonds (Write Down)
CoCo Bonds (Equity Conversion)
50
USD (bn)
40
30
20
10
0
Dec−09 Dec−10 Jan−12 Jan−13 Feb−14
T
Inconsistency in how the conversion to equity takes placeCoCo
Pricing
(APPENDIX)
51
• For Equity Conversion CoCos, the expected loss is determined by the value of the
shares (S*) when conversion takes place : The CoCo investor pays Cp for each share
with value S*: Recovery Rate (%) = RCoCo = S* / Cp
ASSUME: Triggering happens when the stock Rule of Thumb Pricing :
prices hits a certain barrier. CoCo spread = (1 – S* / Cp) x λtrigger
We replace the “CET1 falling below X%”event Equity Model:
by “Stocks hits the a low barrier H”. Smile Adjusted Black-ScholesCoCo
Pricing
:
Equity
Deriva?ves
Approach
(APPENDIX)
52
• We break down a CoCo bond into different derivative instruments:
A. Face Value + Coupons: BOND (long)
B. Conversion into stock: DOWN-AND-IN-FORWARD (long)
Write-down: BINARY DOWN-AND-IN-BARRIER (short)
C. Cancellation of Coupons BINARY DOWN-AND-IN BARRIERS (short)
CoCo Price = A (Bond Part) + B (Loss Absorption) + C (Coupon Loss)
Pricing formula needs essentially two inputs:
Volatility σ and implied trigger level S*You can also read
