The “Unknown Unknowns” of the Contingent Convertible Market

“Reports that say that something hasn’t happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns — the ones we don’t know we don’t know.” — Secretary of Defense Donald Rumsfeld, 12 February 2002

The financial crisis of 2008–2009 highlighted weaknesses in the way banks calculated both their capital ratios and risk-weighted assets (RWAs). Prior to the crisis, banks held too little capital on their balance sheets and did not hold enough liquid funds. These shortcomings led the banks to have large write-downs during the crisis, which in many cases required state intervention to allow the banks to remain solvent.

This post will examine contingent convertible (CoCo) bonds by first looking at the regulatory context that created them and then illustrating some of the issues analysts might encounter when trying to make sense of them.

Basel III Gives Rise to CoCo Bonds

Following the crisis, the Basel Committee released an updated accord, Basel III, to address the shortcomings in banks’ calculations with a particular focus on increasing both the level of bank capital and the “quality” of that capital. The new accord splits Tier 1 capital into two components: Common Equity Tier 1 (CET1) capital and Additional Tier 1 (AT1) capital. Under Basel III, banks must maintain a minimum CET1 capital ratio of 4.5% and a minimum total Tier 1 capital requirement of 6.0%. The 1.5% gap between the 4.5% CET1 capital ratio and the 6.0% minimum total Tier 1 capital is the AT1 capital.

In the European Union, Basel III will be implemented through the Capital Requirements Regulation and Directive (CRD IV), which includes the following requirements for AT1 capital:

• It cannot be secured or guaranteed or have any arrangement that enhances seniority.
• It must be perpetual, with no incentive to redeem.
• Its first call date must be at least five years after issuance.
• It must be able to be written down or converted to CET1 capital upon the occurrence of a trigger event.
• It can receive distributions, but only out of distributable items that are fully discretionary and non-cumulative. AT1 capital coupons can be cancelled by the company or regulators at any point in time. Breach of the combined buffer requirements can lead to the reduction or cancellation of interest payments based on the maximum distributable amount.
• It cannot contain any dividend pushers or stoppers.
• It cannot contain any features that could encumber recapitalization.

Therefore, to fill the 1.5% AT1 capital bucket, a bank could simply issue more CET1 capital. But using CoCo bonds will better optimize the bank’s overall cost of capital because they are cheaper to raise than equity given the tax efficiency of issuing debt. In addition, CoCo bonds will count toward the bank’s regulatory capital buffers and leverage ratios, which will allow the bank to meet its leverage and capital targets without having a higher CET1 capital ratio than necessary. The reason is because the same CET1 capital cannot be double counted and used toward both the minimum capital ratio and the buffer requirements. Given these benefits over issuing common equity, European banks have generally indicated that they intend to meet the 1.5% AT1 capital requirement with CoCo bonds.

Slow Growth

The first CoCo bonds came to market in 2009, but the initial growth of the market was slow because of the ambiguity around eligibility requirements and whether interest was going to be tax deductible. With recent clarification around these topics, the size of the market is expected to grow over the next decade as banks look to replace the old-style Tier 1 hybrid capital, which will lose all of its Tier 1 capital status by the end of 2022.

EU regulators advocate the use of CoCo bonds; they are viewed as a “going-concern solution.” The triggering of the equity conversion or the write-down feature improves a bank’s solvency, importantly without state aid, at a time when raising money in the marketplace would be a challenge because of the financial condition of the bank.

CoCo bonds have polarized the fixed-income investor community. They have become popular with a group of investors who view them as a relatively high-yielding product in a low-yield environment, even when compared with high yield. This camp generally believes that a CET1 capital trigger of 7% or less will not be breached because banks continue to deleverage and build stronger capital positions. Furthermore, bank management would likely act quickly to rebuild the bank’s capital base if it was approaching a trigger level or its CET1 capital ratio suffered a sharp decline. In addition, the chance of European banks increasing leverage or participating in some other form of “event risk” is minimal because financial regulators probably will not currently permit these activities.

Other investors, however, view CoCo bonds as an abomination of the bond market and view them as equity investments.

Significant Complexity

One major challenge in valuing these structures is that, despite the growth of the asset class over the past few years, there is still a lack of consistent structural features. Today, structures can differ in the following ways:

• Loss absorption mechanisms: Does the CoCo bond convert into equity, or is the principal value of the CoCo bond written down? If it converts into equity, is it converted at a fixed price or a floating price? If CoCo bonds are written down, is it a full or partial write-down? And if it is a partial write-down, can CoCo bonds be written back up if the bank’s capital levels recover?
• The level of the trigger: CoCo bonds have been issued with CET1 capital ratio triggers ranging from 5.125% to 8.125%.
• The definition of the equity capital ratio: Although on the surface it appears that CoCo bond triggers are explained by a single number, this number is actually quite deceiving because the definition of the relevant ratio often varies from one CoCo bond to another. This difference in the definition of the trigger ratio distorts the comparability among instruments. Additionally, the reporting of CET1 capital ratios can vary among regulatory regions, with some regions allowing banks to report CET1 capital ratios using the current applicable Basel III guidelines and some regions requiring banks to report on a fully phased-in basis.
• The transparency of the trigger parameter: The trigger for CoCo bonds is generally based on a parameter that is not continuously observable in the market (CET1 capital). The valuation of CoCo bonds would be easier if the parameters used as the trigger were as observable as they are in Mark Flannery’s research paper “Stabilizing Large Financial Institutions with Contingent Capital Certificates.” In his paper, Flannery uses the bank’s “equity ratio,” which is the value of the bank’s market value of equity divided by the book value of its debt outstanding. Both of these factors are continuously observable in the marketplace and are, therefore, more useful numbers for an investor to rely on.

A Little History

The following items could be considered the “known unknowns.” We know these issues could arise, but the unknown variable is how they would be resolved.

• The amount of discretion held by regulators over the trigger feature: Regulators have the ability to put banks into resolution if they believe the bank has reached the point of non-viability (PONV). If this occurs, regulators can force the CoCo bonds to be converted to equity and/or written down. Importantly, this could occur well before the minimum regulatory capital requirements are breached. During the financial crisis, many of the banks that received capital injections from the state reported capital ratios at or more than 5.0%, which is greater than the minimum capital ratio required under Basel II (2.5%). Did the regulators assume that the banks were in worse condition than their reported capital ratios implied? And more importantly, would the regulators react similarly in future crises and trigger the PONV, even if a bank was reporting a capital ratio greater than the minimum amount? Lastly, the degree of tolerance among regulators to a bank approaching its minimum capital ratio in different countries is likely to vary. In other words, a regulator in one country might be more likely to trigger the PONV than might a regulatory organization in a different country.
• The alignment of interest between management, shareholders, and CoCo security holders: Under CRD IV, the maximum distributable amount requires that as capital levels decline, distributions must be restricted. There are three main distributions that can be restricted: common equity dividends, AT1 capital coupons, and discretionary payments to employees (e.g., bonuses). CRD IV does not differentiate between these forms of distributions. In other words, legally they are on equal footing with each other. Despite the fact that in the case of bankruptcy, AT1 capital coupons would rank ahead of common stock, under CRD IV, management could legally turn off AT1 capital coupon payments but continue to pay common stock dividends. Given that management is likely made up of large shareholders of the company’s common stock and discretionary payments are a large part of their compensation, is management more likely to stop coupon payments on AT1 capital first?
• The calculation of RWAs: There is a lack of consistency and transparency in the way in which banks calculate their RWAs. The RWA numbers published by banks are generally modeled outcomes, but the assumptions underlying the outcomes differ greatly between banks. This variance is a concern to regulators, and their continual focus on this issue could lead to increased regulation around the methodology banks use to calculate their RWAs. New regulation is not under the banks’ control and could reduce the capital buffers that issuers have above the trigger for their CoCo bonds.

CoCo securities contain a combination of known knowns, known unknowns because of their complexity and structural differences, and unknown unknowns because as a new asset class there is no history to use as a guide and we don’t know how the market would react exactly to a trigger or a near-trigger event. Because of the unknowns of the asset class, it will provide opportunities but will likely also produce wide variances between the asset class’s best and worst performers.

The focus of the analyst will need to be on the known knowns, such as a bank’s fundamentals and its business model (e.g., retail banks will likely have lower earnings volatility, risk profiles, and management incentives than investment banks). But they will have to remain diligently focused on the known unknowns and the unknown unknowns as the asset class matures.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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