Charterholders connected with financial institutions can expect to hear a lot more about convertible bonds in the next year, especially contingent convertible bonds, or “CoCo bonds” for short. CoCo bonds are a product of higher capital requirements under the new Basel iii regulations, which have put tremendous pressure on financial institutions. While traditional convertible bonds aren’t typically issued by banks and have a market-based strike price that lets holders convert a bond into a certain number of shares, CoCo bonds are different. They’re issued by financial institutions and come with triggers contingent on the regulatory capital of the issuer. The latest push for CoCo bonds comes as a result of aggressive capital requirements imposed by Swiss regulators. Swiss banks UBS and Credit Suisse, for example, must now have capital ratios of 19 percent, and up to 9 percent of that can be in the form of CoCo bonds.

Proponents of CoCo bonds say they are an inexpensive means to meet capital targets. The CoCos come on the balance sheet as debt, but a trigger that is tied to regulatory capital means they would switch into loss-absorbing equity in the event of emergencies.

Cool on CoCos

CoCo bonds have generated a good deal of skepticism, however. The academic literature has erupted with investigations into these poorly understood instruments and has advanced some proposals on how to change or refine them to avoid pitfalls. Questions tend to focus on three debatable grey areas: the share conversion price, how the trigger is measured (accounting vs. market-driven numbers), and the capital ratio at the trigger (high vs. low, going concern vs. gone concern). There is debate over whether CoCos are “going concern” and would in fact be able to convert before the “point of non-viability” of a financial institution.

Critics point out that a trigger based solely on regulatory capital may not have a suitably short response time or be sensitive enough to changes. In the accompanying figure (from a presentation made by Bank of England executive director Andrew Haldane), a distinction is made between banks that had and did not have extreme distress in autumn 2008 (lines marked “crisis” and “no crisis” respectively). Figure 1 shows two panels. The first shows that the two lines are nearly coincident for regulatory capital. In the second panel, the two lines show great disparity for the ratio of market cap to book value for two years prior to the collapse of the “crisis” banks. However, fixing the problem is not as simple as changing to a purely market-based trigger because conversion could have an unduly negative signalling effect. If the trigger is market-based, that could be open to manipulation and lead to “death spirals.”

CoCo bonds or their variants are not yet issued by Canadian banks. There is an opportunity to mitigate design flaws in the Swiss model. Here in Canada, some fear there may be regulatory reluctance to set a hard trigger that will react with the necessary speed. Keeping discretionary power in the hands of the regulator would allow the office of the Superintendent of Financial institutions (OSFI) to respond quickly, if needed, without waiting for the regulatory capital to nosedive. For the moment, however, Canadian banks are waiting for clarity on CoCo bonds. OSFI will have to decide where, within a healthy balance sheet, CoCo bonds will rank and whether or not they are new instruments or simply variants of existing debt.

The challenge for investors will be deciding whether they have room in a bond portfolio for an instrument that is convertible to common equity when the going gets tough. At what point will the new instruments be considered equity and not a bond? When will it be convertible and what will the trigger look like? Right now, say experts, there is little clarity around some of these important questions, but ideally the trigger design will be a collective decision, made well in advance, rather than an ad hoc decision made under pressure.

At the same time, the banks know they need to understand all possible permutations of the new instruments before bringing them to market. According to George Pennacchi, Professor of Finance at University of Illinois, the “most critical” component of the valuation model will be the ability to handle “jumps,” the sudden extreme losses such as those that happen in a financial crisis. In a paper called “Contingent Capital: The Case for CoerCs,” Pennacchi and co-authors propose a variation on CoCo bonds called COERCs, Call option enhanced reverse Convertible bonds, a security that would take its cue from the market but contain safeguards against market manipulation.

For now, there is much ado about CoCos. Clearly, charterholders face a few blind spots when it comes to understanding how they work and what the triggers are. As OSFI mulls its reaction to CoCos, charterholders should make sure they’re aware of what the angles and possible outcomes are when it comes to this new kind of security.

CoCo Bond Redesign*

Financial institutions want to design low-cost securities that will quickly inject capital in “dire situations.” Here’s a wish list from Professor Theo Vermaelen:

1. It must avoid bankruptcy by treating the bank as a going concern;
2. It must contain market-based, not capital ratio, triggers. A caveat is that this could lead to market manipulation;
3. It must avoid “death spirals,” i.e., economically unjustified conversions caused by shorting the stock and buying the bond;
4. It must not have multiple equilibria;
5. Issuance or conversion of such a security should not give a negative signal;
6. The taxpayer would never have to bail out a CoCo bond;
7. Interest should be tax-deductible in order to make these attractive to issuers;
8. Valuation should be able to handle jumps;
9. It must be low risk to attract risk-averse investors;
10. It must be easily valued by credit rating agencies;
11. It must avoid “risk shifting” and debt overhang problems.

*Source: INSEAD – Contingent Capital: The Case for COERCs, George Pennacchi, Theo Vermaelen, Christian C.P. Wolff. presented at GARP, November 2012.