By Brendalee Scott-Novak, Butterfield
The first six weeks of 2016 witnessed a wave of credit losses across fixed income markets. Most notable was the broad-based selloff in contingent convertible bonds commonly known as CoCos. The market’s shudder appeared to be driven partly by a European Banking Authority year-end report that sought to clarify potential triggers for restrictions on distributions.
A direct corollary of this newfound knowledge was heightened awareness of the significant risks inherent in these hybrid securities of Europe’s least capitalized banks. Even as markets continue to roil from the oil shock, a confirmed slow down in China and nosedive in corporate earnings, the recent news mounted further concerns on banks’ ability to make their coupon payments on CoCos. Spreads within this $150 billion sector increased from 445bps to 636bps above three-month LIBOR, endangering the market for this high yielding debt.
So what is this credit sector that sparked such panic and led industry titans to be gasping for air? According to Bloomberg, CoCos are securities similar to traditional convertible bonds having a strike price. This strike price is the value of the shares when the bond converts into equity. The difference between a CoCo and a traditional convertible bond is the existence of another price, which is typically higher than the strike price. This additional stock price must be reached before an investor has the right to make the conversion from bond to equity. This is referred to as the “upside contingency.” CoCos are typically perpetual bonds and are the first debt security in line to absorb losses when the bank fails to meet its capital requirements.
Financial institutions choosing to undergird their capital structure can issue 1.5 percent Additional Tier 1 (AT1s) or 2 percent Additional Tier 2 (AT2s) CoCo bonds. While Tier 2 CoCo bonds are designed to absorb losses only, Tier 1 CoCos may have their coupon canceled, maturity extended or complete loss of capital including a non-viability option, should capital levels fall below the required threshold. Yielding some of the most attractive returns within the debt market, CoCos exhibit negative convexity given the limited upside and potential for unlimited losses. Investors of AT1s will receive coupon payments but cannot be compensated for missed payments via higher distribution when the bank is profitable, as in the case of equity holders. Coupon payments on CoCos are therefore heavily dependent on capital levels, as banks stand subject to restrictions on earnings distribution should total capital fall below the sum of Pillar 1, Pillar 2 and other combined capital buffers.
Given the perceived risks inherent in these types of securities, why do they continue to garner oversubscription upon issuance? Following the credit crisis of 2008, CoCos were created to preserve capital in a distressed lender, shifting the burden of failure from taxpayers to investors. Should a bank face insurmountable losses, this contingent form of capital will bolster a bank’s capital, diluting existing shares at the trigger point. By simply canceling outstanding coupon payments, CoCos can aid banks avoid a default. Although these securities remain some of the most expensive form of debt in the capital structure, they have somehow become a panacea for banks struggling with dividend payouts, shrinking operations and thin profit margins. As regulators mandate capital buffers to unsustainable levels, banks are relying on these complex securities to fill regulatory gaps, while investors, hungry in their search for yields, are finding much relief given the negative interest rate environment.
Issuing contingent convertible bonds is more advantageous to companies than issuing traditional convertibles. If the option is not exercised, shares are excluded from the company’s calculation of diluted earnings. This accounting advantage may be short-lived, however, as the Financial and Accounting Standards Board’s Emerging Issues Task Force has proposed an accounting rule change that would eliminate this accounting advantage.
Given the tripartite crossfire from divergent interpretation among national regulators, banks’ expected actions on guidance versus sanctioned Pillar 2 requirements and the elevated cost of CoCos, what is the future for this sector? It is estimated that the market for contingent convertibles points may double to more than 240 billion euros (US$271 billion) by 2020 as regulators up the ante on higher and more restrictive capital requirements.
The European Commission’s recent suggestions to provide some protection to holders of AT1 capital notes is indicative of the pressure to make investment in CoCos easier. The recent panic is also testament of investors’ lack of certainty on the optionality intrinsic to CoCos and the factors that qualify for coupon cancellation. These ongoing uncertainties, three years into their existence, point to even further volatility as markets adjust to reflect the different levels of risk our changing environment has fashioned.
European regulators are now faced with the daunting task of creating greater transparency, clarity and consistency transcending national borders, if these hybrid securities are to become a mainstay in protecting taxpayers.
Disclaimer: The views expressed are the opinions of the writer and while believed reliable may differ from the views of Butterfield Bank (Cayman) Ltd. The bank accepts no liability for errors or actions taken on the basis of this information.
Statistics and Data Source: Bloomberg LP., BCA Research, Federal Reserve