Coco bond

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A Coco bond or conditional mandatory convertible notes (English contingent convertible bond or short coco bond ) is a long-term subordinated loan with mostly fixed coupon which automatically upon the occurrence of predetermined events (conversion criteria) of debt into equity changed is. These hybrid bonds make lenders liable to shareholders in the event of conversion and improve the issuer's equity base. If the conversion criteria are set appropriately, this happens especially in economically unfavorable situations for the company. Without triggering the conversion, the Coco bond continues to run normally until it is redeemed at the end of its term. In contrast to conventional convertible bonds , conversion takes place automatically and there is no exchange or option for the investor. As a result of the financial crisis from 2007 onwards, Coco bonds were discussed for large financial institutions in order to get a better grip on future problems of systemically important banks.

Coco bonds are particularly suitable for issuers with below average credit ratings. A conversion gives the company - often a financial institution - new equity without the need for a capital increase or government aid, while its interest obligations decrease at the same time. Liability for any undesirable developments in the company is thus partially transferred to the subscribers of the Coco bonds. This mechanism may enable third parties to be protected against necessary interference in the sense of a liability-like obligation. When converted, Coco bonds do not bring new money in the form of liquidity, but rather strengthen the company by converting debt into equity.

Design of Coco bonds

When it comes to the design of Coco bonds, the choice of the trigger event , the conditions under which conversion takes place and the term play an important role. These parameters should be selected appropriately for the individual company situation.

Conversion trigger

The conversion trigger specifies the circumstances under which conversion into equity and thus a strengthening of the company's capital base takes place. It can be accounting-oriented, market-based, regulatory or referring to several systems.

Accounting-oriented trigger

A first variant is to use the accounting parameters as a guide when defining the trigger. The risk-weighted equity or the equity ratio can be used as a reference value. This makes sense because the conversion directly improves the equity ratio. However, since accounting-based variables are usually available no more than half-yearly or quarterly, the trigger only reacts with a corresponding delay. It would therefore be conceivable to carry out special audits and to check the criteria in smaller periods. However, this requires a prior definition of the decision criteria and the choice of an independent decision maker. Other problematic aspects concern the dependency of the balance sheet values ​​on the underlying accounting standards, the quality of the processed data and political pressure.

Market based trigger

Triggers that are based on market-based parameters such as share prices or credit spreads (CDS spreads) are easy to determine and transparent. These can be tracked daily by the investors as well as the bank. The risks here lie in the implied volatility as well as in the possible influence on the share price to bring about a desired conversion.

Regulatory trigger

Another approach is chosen with triggers that delegate the decision about the conversion to the regulator. If the respective national banking supervisory authority is of the opinion that an institution is in difficulties and may no longer be able to meet its obligations, the conversion should be ordered. Such a decision could be linked to the negative result of a stress test, which embodies an early conversion criterion with a preventive character. The question remains, however, on what basis the regulator should be able to make better decisions than other actors.

Multivariate trigger

The reference systems outlined above are each based on one dimension. Dual triggers, in which two conditions have to be fulfilled at the same time, can put the specific disadvantages of the above reference systems into perspective. Since Coco bonds are an institution-specific instrument, a multivariate trigger should also include bank-specific factors. According to the Squam Lake Working Group on Financial Regulation (2009), the conversion into equity should be linked to two conditions. On the one hand, the regulatory authority must declare a systematic crisis, on the other hand, the financial institution must be in serious trouble.

Conversion share and price

The conversion percentage determines which percentage of the Coco bonds will actually be converted into shares in the event of the conversion being triggered. This does not have to be 100 percent, but simply ensure that the minimum equity is reached again. How many shares the bond investors receive depends on the conversion price - this can be based on the share price on the date of issue of the Coco bond, at the time the conversion criteria were triggered or an (average) price between the two times.

The institution-specific purpose of Coco bonds is largely determined by the choice of the conversion threshold. In this context, a high conversion trigger means that the threshold that is a prerequisite for conversion is reached quickly if the institute is in financial difficulties (ongoing restructuring buffer). Equally meaningful, the change takes place at a relatively late point in time in the event of a deep change trigger, for example to provide protection during a systemic crisis. In the latter case, Coco bonds would be insurance for bad times, as conversion only takes place in an emergency. This makes them more attractive for institutional investors as they are easier to assess. In addition, the higher the threshold from which conversion takes place, the more expensive the Coco bond will be for the issuing institution. The following table shows how the trigger variants are designed.

Coco bonds with contractual release With high trigger With a deep trigger
description The trigger is set so that the conversion takes place at an appropriate distance from the regulatory minimum. The trigger is just above the regulatory minimum.
Loss-bearing capacity during operation High if conversion or write-off takes place quickly (building trust is crucial). Significantly weaker and later onset of effect than higher triggering Coco bonds, since even in acute crisis situations the capital ratio shown can still be above the regulatory minimum.
Importance in a crisis situation Rapid stabilization, even before the actual restructuring and liquidation phase. Stabilization, ensuring sufficient room for maneuver in the event of a crisis and contributing to reorganization and orderly liquidation.

Terms

Another feature of the Coco bonds is the definition of the term. In addition to the institute-specific needs, this should be based on the various investor groups and their interests. If you take into account the intended function of Coco bonds to ensure crisis prevention for financial institutions, long-term maturities are obvious.

Marketability of Coco Bonds

In terms of marketability, investors' interests, pricing, the influence of rating agencies and possible dangers such as the downward spiral must be taken into account.

Investor interest as a factor of uncertainty

Since Coco bonds are new types of paper and investors tend to become shareholders at an inconvenient time, the placeability remains open and difficult to assess. Success sometimes depends on whether enough institutional investors can be found. The following table lists the possible customer groups and their interests.

Classic bond investors Hedge funds Employees at credit institutions
  • May have problems holding converted Coco bonds, especially with FI investors.
  • Many institutional investors are legally prohibited from investing in mandatory convertible bonds.
  • Without the participation of traditional investors, however, Coco bonds are unlikely to catch on.
  • Accounting treatment unclear.
  • New target groups with a higher risk-return profile than investors in previous hybrid bonds.
  • In addition to hedge funds, wealthy private customers can also be considered.
  • Both could add Coco bonds to their portfolios to optimize returns (if the risk is difficult to assess).
  • Conceivable as variable remuneration.
  • Positive side effect in influencing the incentive structures.
  • Small share of the market (10–25%) and overall too small to accommodate large parts.
  • Possible problems in the practical implementation that lead to a capital deduction from regulatory capital.

Pricing

If Coco bonds serve to strengthen the equity base, the decisive factor is whether they are cheaper than equity. Therefore, the cost of equity should in principle be seen as the upper limit for the cost of this financial instrument. Since investors run the risk of becoming shareholders at an inopportune time, a higher coupon can be expected for the lower limit than for convertible bonds. This option element (short put option) to be settled is a burden for the investor and is in contrast to conventional convertible bonds, where this option represents an asset. From an investor's point of view, the risk-return constellation is generally decisive, which is currently particularly attractive in phases of low interest rates. Issuing the instruments by the issuer is therefore relatively expensive, especially with optimistic financial perspectives. Since Coco bonds initially flow into the balance sheet as debt capital, the tax deductibility of the resulting interest expenses can reduce costs.

In practice, different amounts of coupon payments with different payments have so far developed. Conclusion of the risk based on the coupon amount is therefore hardly a conclusive concept. Rather, the required risk premium for Coco bonds is currently still unclear and will continue to be based on different indicators based on the institute-specific factors. In 2011, market forecasts assumed that the interest rate would level off between 8% and 9%.

Evaluation by rating agencies

Investors' ability to invest is sometimes dependent on whether Coco bonds are listed in indices for fixed income securities. However, this inclusion is questionable due to the design-related equity elements. A rating is usually required for inclusion in bond indices. Institutional investors are also often only allowed to invest in rated securities. That is why the handling of the rating agencies with the Coco bonds is important for the marketability of the instruments. The difficulties involved in issuing such a rating lie in the calculation of the conversion probability, its changes and the question of the extent to which these depend on the issuer's rating adjustments.

Basically, with Coco bonds, credit discounts are to be expected compared to conventional bank bonds, as they contain multi-layered risk constellations. Due to the difficult risk assessment, the rating agencies Standard and Poor's and Moody's have so far (as of 2011) dispensed with a rating. Moody's denied the creditworthiness of Coco bonds in 2010: "the unpre-dictable and non-credit linked elements surrounding these triggering events make the instruments un-suitable for a fixed income rating." Fitch, the third major rating agency, will use the existing approach the unsupported issuer default rating (IDR). The announced gradation illustrates the critical view and thus the limited marketability of Coco bonds.

Dilution effects and downward spiral

When converting bonds into equity, there are basically two dilutive effects. On the one hand, the conversion of the title increases the number of shareholders, and the voting rights of the existing shareholders are diluted. On the other hand, when new shares are issued, capital dilution effects occur if the issue price of the new shares is below the current market price. If, for example, the conversion price of an ordinary convertible bond is close to the share price, there may already be a dilution when these securities are issued. Normally, these dilution effects are eliminated by issuing subscription rights. In the category of conditional convertible bonds, on the other hand, this effect does not usually play a role. In the case of Coco bonds, the risk of dilution is therefore to be classified as lower than with a normal convertible bond. Due to the structure already explained, the option component of Coco bonds can be classified as having little economic value, which is compensated for by a higher interest rate. An advance subscription right (subscription right) would therefore only have a low value.

However, this reasoning only applies in a stable economic environment. In a tense environment with stressful and crisis situations, when an institution has to replace or supplement Coco bonds and the occurrence of the conversion appears likely, other mechanisms come into play. In such a scenario, the Board of Directors can exclude or limit the advance subscription rights of the previous shareholders for important reasons. In this case, however, he is required to issue the Coco bonds at market conditions. In this regard, existing shareholders have to accept a discount in favor of the placeability of Coco bonds. Company interests and system protection are therefore in the foreground, which is why existing shareholders have to grant the Board of Directors certain discretion.

However, there is an inherent risk of legal action against members of the Board of Directors in the event of the unusual design of Coco bonds. Another potential risk for the financial institution from the described relationships lies in a downward spiral in share prices. A pending conversion and the threatened dilution could induce previous shareholders to sell their shares. The flooding of the market in turn harbors the risk that market participants tend to have problems with a financial institution and set in motion a downward spiral in prices.

Swiss legal situation

Since the too-big-to-fail proposal came into force on March 1, 2012, according to Art. 11 in conjunction with Art. 13 of the Banking Act, banks as well as groups and conglomerates with a majority of financial interests are authorized to issue Coco bonds by resolution of the General Assembly. However, it can only be offset against the issuer's own funds if the issuing conditions have been approved in advance by FINMA . If the event occurs, which according to the law must be objectively determinable, the Board of Directors determines the conversion into equity by means of a public deed. The conversion must be entered in the commercial register immediately; the commercial register cannot be blocked. Use of coconut for purposes other than strengthening equity, e.g. for mergers or takeovers, is excluded. A possible exclusion of the advance subscription right is only possible by resolution of the General Assembly.

criticism

Coco bonds have only come onto the market in the last few years, especially after the financial crisis . They are rated critically by some experts:

  • Coco bonds are usually converted from debt to equity when the equity ratio falls below a certain level. This is very helpful for the debtor who is then obviously in a difficult financial situation. Instead of the bond, however, the creditor receives shares in an institution in distress as a replacement, which in the worst case are worthless.
  • The interest servicing of the Coco bonds is tax-deductible on the part of the bank - like other interest expenses. According to Basel III , however, the bonds are valued at credit institutions like equity, which is usually serviced from earnings after taxes. The hybrid character means that the issuer has tax advantages . The disadvantages, however, lie with the state as the tax collector.
  • It seems questionable whether the risks of a Coco bond are always presented in a sufficiently understandable way to a private bank customer by the issuing bank, especially if the bank has its own interests in issuing the bonds.

Individual evidence

  1. ↑ RN Collender, FW Pafenberg, RS Seiler: Automatic Recapitalization Alternatives . 2010, p. 7-9 (English).
  2. ↑ Thomas Heidorn, Mirko Gerhold: Investments and issues of convertible bonds. (PDF) In: Arbeitsberichte der Hochschule für Bankwirtschaft No 50. 2004, accessed on August 10, 2015 .
  3. ↑ Contingent Convertibles: Bank Bonds in Transition . In: Deutsche Bank Research (Ed.): Finanzmarkt Spezial . 2011, here p. 5 .
  4. ^ J. De Spiegeleer, W. Schoutens: Pricing Contingent Convertibles: A Derivatives Approach . 2011, here pp. 4–5 (English).
  5. ↑ a b T. Berndt, J. Vollmar, R. Becker: Requirements for the design of coco bonds . 2012, here p. 128 .
  6. ^ RL McDonald: Contingent Capital with a Dual Price Trigger . 2010, here p. 22 (English).
  7. ↑ a b Contingent Convertibles: Bank Bonds in Transition . In: Deutsche Bank Research (Ed.): Finanzmarkt Spezial . 2011, here p. 8 .
  8. ^ RL McDonald: Contingent Capital with a Dual Price Trigger . 2010, here pp. 22–24 (English).
  9. ↑ K. Kamada: Understanding Contingent Capital . 2010, here p. 38 (English).
  10. ↑ B. Rudolph: The introduction of regulatory crisis capital in the form of contingent convertible bonds (CoCos) . 2010, here p. 1154 .
  11. ↑ T. Berndt, J. Vollmar, R. Becker: Requirements for the design of coco bonds . 2012, here p. 129 .
  12. ^ Squam Lake Working Group on Financial Regulation. (2009). An Expedited Resolution Mechanism for Distressed Financial Firms: Regulatory Hybrid Securities. P. 4.
  13. ↑ T. Berndt, J. Vollmar, R. Becker: Requirements for the design of coco bonds . 2012, here pp. 129–130 .
  14. ↑ C. Pazarbasioglu, J. Zhou, V. Le Lesle, M. Moore: Contingent Capital: Economic Rationale and design features . 2011, here pp. 9–11 (English).
  15. ↑ Contingent Convertibles: Bank Bonds in Transition . In: Deutsche Bank Research (Ed.): Finanzmarkt Spezial . 2011, here pp. 6–7 .
  16. ↑ Swiss Confederation. (2010). Final report of the expert commission on the limitation of macroeconomic risks by large companies. Pp. 26-27.
  17. ↑ Contingent Convertibles: Bank Bonds in Transition . In: Deutsche Bank Research (Ed.): Finanzmarkt Spezial . 2011, here p. 9 .
  18. ↑ W. Enz: The CoCo market should fix it . In: Neue Zürcher Zeitung . October 7, 2010, p. 27 .
  19. ↑ Contingent Convertibles: Bank Bonds in Transition . In: Deutsche Bank Research (Ed.): Finanzmarkt Spezial . 2011, here pp. 10–11 .
  20. ↑ M. Tommaso: What makes Coco Bonds attractive . In: Finance and Economy . April 28, 2012, p. 16-17 .
  21. ↑ C. Pazarbasioglu, J. Zhou, V. Le Lesle, M. Moore: Contingent Capital: Economic Rationale and design features . 2011, here p. 13 (English).
  22. ↑ MP Bürgi: Tricky pricing for CoCo . In: Neue Zürcher Zeitung . March 29, 2011, p. 29 .
  23. ↑ Contingent Convertibles: Bank Bonds in Transition . In: Deutsche Bank Research (Ed.): Finanzmarkt Spezial . 2011, here p. 16 .
  24. ^ J. De Spiegeleer, W. Schoutens: Pricing Contingent Convertibles: A Derivatives Approach . 2011, here pp. 12–13 (English).
  25. ↑ GM Furstenberg: Contingent capital to strengthen the private safety net for financial institutions: Cocos to the rescue? 2011, here p. 13 (English).
  26. ^ G. Pennacchi, T. Vermaelen, C. Wolff: Contingent Capital: The Case for COERCs . 2011, here p. 4 (English).
  27. ^ P. Bolton, F. Samama: Contingent Capital and Long Term Investors: A Natural Match? 2010, here p. 38 (English).
  28. ↑ Contingent Convertibles: Bank Bonds in Transition . In: Deutsche Bank Research (Ed.): Finanzmarkt Spezial . 2011, here p. 11 .
  29. ↑ Swiss Confederation (Ed.): Final report of the expert commission on the limitation of economic risks by large companies . 2010, here p. 93 .
  30. ↑ a b R. Wide Cross, J. Vollmar: contingent convertible bonds crisis prevention . 2011, here p. 151 .
  31. ↑ Swiss Confederation (Ed.): Final report of the expert commission on the limitation of economic risks by large companies . 2010, p. 86-93 .
  32. ^ MJ Flannery: Stabilizing Large Financial Institutions with Contingent Capital Certificates . 2009, here p. 18 (English).