09 April 2014

New CoCos are coming. But with which coupons?

Beside the issuer, structure and recovery rate are the key determinants
Contingent Convertibles (CoCo) are high yielding debt instruments, issued by banks and insurance companies, which
have recently come to the forefront of capital markets, fuelled by the new regulatory climate post the credit crunch crisis.
The main idea is that the CoCo investor, rather than the taxpayer, suffers losses if the issuing financial institution ever
comes into a life threatening scenario. The loss mechanisms are pre-defined; the bonds will either convert into equity or
face a full or partial write-down. The point at which such losses takes place is typically defined in terms of a bank's core
equity Tier 1 ratio (CET1) falling below a certain level, known as the trigger level. CoCo securities are issued either with
low trigger levels (e.g. CET1 falling below 5% or 5.125%) or with high trigger levels (usually 7% CET1 triggers). In
addition, a number of bonds are subject to a regulatory trigger; that is the national regulator could trigger the CoCo if they
feel the bank is entering a point of non-viability. As well as being subject to different trigger levels and loss absorption
methods, CoCos can take a multitude of different forms, whether it is due to their structure (Tier 1 or Tier 2), maturity, call
schedule or currency.
Since the very first issuance of CoCos by Lloyds Bank back in 2009, a gradual clarification of the legal and regulatory
requirements for CoCos has been followed by an accelerating issue activity. More than half of the current 60 billion EUR
in European Bank CoCos have been issued since the second half of last year. Most of these have seen extremely high
demand from investors, for example the BBVA 7% Tier 1 CoCo from February 2014 attracted 14bn EUR demand for a
1.5bn EUR issue size, and broke almost 1.5c higher in the secondary markets; the new UBS 4.75% Tier 2 CoCo saw
demand above 10bn EUR and performed similarly. Indeed, the average deal in 2014 was more than twelve times
oversubscribed.
In order for banks to shore up their capital base as required by Basel III, and in particular due the upcoming stress test
and Asset Quality Review exercise, many market participants are expecting banks to tap capital markets with substantial
amounts of new CoCos. Many analysts estimate this at 30 50 billion EUR in 2014 alone. Regarding the European
stress tests, the higher trigger CoCos will be of particular interest since the ECB is said to favour a 6% capital
requirement, and therefore, these higher trigger CoCos provide protection at earlier stages of a loss-driven erosion of the
balance sheet. For those banks which need to come to the market with new CoCos, it is important to determine a fair
coupon at which these securities should be priced. However, determining the appropriate yield is not an easy exercise
and a variety of models have developed for this task (see for example [1]). In this article, we model a variety of generic
CoCo structures, and determine a fair coupon based on current market information and through benchmarking them
against recently issued CoCos.
By example, we apply this to some key European banks, namely BNP Paribas, Deutsche Bank, HSBC, ING Bank and
Intesa Sanpaolo. Deutsche Bank has announced already in the press they are considering issuing up to EUR 5 billion
CoCos in the near term, while others appear to be on stand-by.
The fair coupon of a CoCo depends on many aspects. Beside issuer specific factors, the recovery value of the bond an
investor can expect in case of a trigger event is of critical importance. To illustrate the role the recovery plays in valuing
CoCos, we consider 3 different structures: a full write-down CoCo, a CoCo converting into equity with a conversion price
equal to the price at issuance date, and a CoCo with a conversion price equal to 60% of the spot price at issuance. The
final variant is inspired by the recent Tier 1 CoCos which Barclays have issued, where the conversion price was 66%
percent of the spot.
Considering these three structures, we see key differences in the respective recovery rates. Indeed, in the case of a full
write-down CoCo, the recovery rate is clearly zero. For the other two CoCos, the recovery rate is not determined upfront
but depends on the stock price at the trigger date. Assuming that the stock price on trigger date equals 30% of the
current spot price, the recovery rate for the CoCo with a conversion price equal to the spot at issuance will be exactly
30%; while the recovery rate for the third CoCo will even be higher and will equal 50% (=30/60). Clearly this has an
impact on the fair coupon determination. Using current market data including current credit default swap levels, interest
rates, dividend yields and volatility levels, and employing an equity derivatives model [1], this leads to the following table
of fair coupons for the three types of higher trigger CoCos described above. 'High trigger' here represents a 7% trigger,
and here we consider a Tier 1 structure, with first call after seven years. Since almost no CoCos offered in the markets
are identical, the ranges only apply for the generic standard CoCo described and are purely indicative.

09 April 2014

From the bank's perspective of course it makes sense to offer structures with a low coupon, in order for them to be able
to finance more cheaply, and hence the structure with conversion at 60% of issue spot price, makes the most sense in
our view. We see, for such a perpetual structure, with first call after seven years, the modelled coupons come in the
range of 6.375% to 7.5%. We note that the latest Barclays CoCo of this type was a non-call 7 year perpetual, and was
1
issued with an 8% coupon. Taking into account that it had rallied since issuance , we see that our modelled results are
quite in line with where the Barclays CoCo currently trades.
A similar exercise could be made for low trigger CoCos, taking here a trigger level of 5.125% CET1. The level is the
minimum allowed by the Basel committee's CRD4 regulations in order for the instrument to qualify as Additional Tier 1
capital. Since, these CoCos typically will trigger later in the game, the risk an investor will suffer losses is smaller than
that of a high trigger CoCo. However, from a recovery rate perspective, investors should typically experience a lower
recovery, since the stock price at trigger will trade at a lower level. In such cases, the bank will have already suffered
from larger capital losses which will have already breached through the 7% trigger level, and therefore, the equity will be
trading at even more depressed levels. The impact on the coupons can be found in the below table, again assuming a
Tier 1 structure with first call after seven years.

Note there is also a small difference in conversion price: for Barclays it was 66% of spot, while our generic CoCo uses 60% of spot.

09 April 2014

References
[1] 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.
[2] Hnseler, M. (2013). Credit Portfolio Management: A Practioner's Guide to the Active Management of Credit Risks,
Palgrave McMillan.
Assenagon Asset Management S.A.
Prannerstrae 8
80333 Mnchen
Michael Hnseler
Telefon +49 89 519966-401
michael.huenseler@assenagon.com
Dr. Stephan Hcht
Telefon +49 89519966-361
stephan.hoecht@assenagon.com
Robert Van Kleeck
Telefon +49 89 519966-404
robert.vankleeck@assenagon.com
Prof. Dr. Wim Schoutens
Telefon +49 89 519966-151
wim.schoutens@assenagon.com