Understanding Contingent Convertible Securities: A Primer

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1 May 2016 Understanding Contingent Convertible Securities: A Primer By Erin McHugh, CFA While a contingent convertible security (CoCo) may sound like a sweet treat, it is actually a novel hybrid financial instrument that has recently been in the headlines. Since 2009, banks have issued more than USD 380 billion of CoCos. To date, no CoCo has missed a coupon payment or has experienced a trigger event. However, recent market turmoil may have some investors reassessing their appetite for these securities. This white paper provides a brief introduction to CoCos, describing their characteristics and risks, as well as issuance trends to date. The author also discusses recent developments in the markets for these securities and potential future challenges that issuers and investors may face. Product Characteristics CoCos are securities, issued by a bank, that are designed to absorb the bank s losses during a period of financial stress, thereby improving its capital position. CoCos absorb losses by automatically converting to equity or having their principal written down (either partially or in full) when a pre-specified trigger event occurs. Absent a trigger event, the securities are hybrid financial instruments with debt-like characteristics (such as a specified coupon rate). CoCos are subordinated to senior debt within the bank s capital structure. CoCos were first issued in the aftermath of the 2008 financial crisis. Lloyds Banking Group s November 2009 offering of enhanced capital notes (ECNs) is generally recognised as the first issuance of CoCos. Some regulators have encouraged CoCo issuances to reduce the likelihood of taxpayer bailouts such as those that were required during the financial crisis. Depending upon the specific features of the security, CoCos can qualify as Additional Tier 1 (AT1) or Tier 2 (T2) capital under the Basel III international regulatory framework for banks. To qualify as AT1 capital, CoCos must be perpetual instruments with coupon payments that can be deferred or cancelled at the issuer s discretion without causing an event of default.

2 CoCos are more complex than most conventional debt instruments. For an investor, key considerations include the probability of a trigger event (i.e., the probability that the security will be forced to absorb losses) and the potential losses if a trigger event occurs. To date, most issuances of CoCos have had accounting-based triggers and/or discretionary triggers: 1 An accounting-based trigger is activated if a capital ratio (e.g., the Common Equity Tier 1 ratio) drops below a specified level. The specified levels can vary, with higher triggers intended to provide additional equity capital at earlier intervention points. A discretionary trigger gives the bank s national regulator responsibility for triggering the CoCo when it has determined that the issuer has reached the point of non-viability. In order to evaluate the probability of a trigger event, the transparency of the trigger mechanism is important. For CoCos with accounting-based triggers, it may be difficult to forecast the future evolution of the issuer s capital ratio. With a discretionary trigger, it can be difficult to predict the regulator s use of its discretion. For AT1 CoCos, there is also the risk that the issuer may defer or cancel coupon payments (which can occur even while the issuer continues to pay dividends on its common stock). Also, even when an issuer is able and willing to make interest payments on AT1 CoCos, it could be prevented from doing so by the regulator. A regulatory call provision allows the CoCo to be repurchased by the issuer if the regulatory environment changes and the security no longer qualifies as required capital. A tax call provision allows the CoCo to be repurchased by the issuer if the tax treatment of the CoCos changes (for example, the tax deductibility of interest payments). AT1 CoCos, while perpetual in nature, are generally callable by the issuer after a stated period (a minimum of five years in order to qualify as AT1). Many T2 CoCos are also callable by the issuer. Additionally, most CoCos include regulatory call and tax call provisions. A regulatory call provision allows the CoCo to be repurchased by the issuer if the regulatory environment changes and the security no longer qualifies as required capital. A tax call provision allows the CoCo to be repurchased by the issuer if the tax treatment of the CoCos changes (for example, the tax deductibility of interest payments).if securities are called at par, and if purchases were made at prices above par, this can result in losses for investors. Moreover, investors may not be able to reinvest the call proceeds at comparable rates (referred to as reinvestment risk). The possibility of a regulatory or tax call is an important consideration for investors. Issuance to Date Investors search for yield in a low-interest rate environment may have played a role in the willingness to accept the risks associated with CoCos. Since 2009, banks have issued more than USD 380 billion of CoCos. 2 After a rapid rise between 2009 and 2013, issuance peaked at USD 175 billion in. Issuance in was down 42% from its level. Moody s noted that in a number of banks postponed their CoCo issuances due to weak market conditions associated with the Greek debt crisis, concerns about China s economic growth, and uncertainty surrounding a rate hike by the U.S. Federal Reserve. 3 See Figure

3 Figure 1. Issuance of CoCos (USD Billions), 2009 $175.0 $101.2 $49.6 $13.9 $3.7 $14.8 $ Notes and Sources: Data are from Moody s Investors Service, Moody s Quarterly Rated & Tracked CoCo Monitor Database Year End. AT1 CoCos represented 76% of the total issuance volume (by amount) in (as compared to 52% in 2009 ). European and Asian banks have represented the largest CoCo issuers by volume. See Figure 2. US banks have not issued any CoCos for reasons which may include: a) uncertainty as to the tax deductibility of interest payments on CoCos under IRS guidance, and b) the fact that US regulators do not currently allow CoCos to qualify as AT1 capital under their implementation of the Basel III framework. 4 Figure 2. Issuance Amount of CoCos, by Region (USD Billions), % 48% 42% Europe 1 Asia Pacific Other 2 Notes and Sources: Data are from Moody s Investors Service, Moody s Quarterly Rated & Tracked CoCo Monitor Database Year End. 1 Includes Europe Euro Area and Europe Non-Euro Area. 2 Includes North America, Latin America, and Middle East & Africa. 3

4 While CoCos have primarily been issued by banks to date, Moody s recently noted that many insurers are examining CoCo issuance given low interest rates and successful issuance from banks. 5 Purchasers of CoCos have included retail investors, hedge funds, asset managers, and private banks. Credit Ratings All three main credit rating agencies Moody s, Standard & Poor s, and Fitch rated Lloyd s ECNs, issued in November In February 2010, Moody s established a moratorium on rating CoCos where loss absorption was subject to regulatory discretion and/or the breach of regulatory capital triggers, citing lack of clarity and potential modeling difficulties. 6 In May 2013, Moody s decided to end its ratings moratorium on CoCos with regulatory capital triggers set at or near the point of non-viability (i.e., low trigger CoCos), but maintain its moratorium on rating high trigger CoCos. 7 In July, Moody s ended its moratorium on rating high trigger CoCos. 8 Figure 3 shows the number of Moody s-rated AT1 and T2 CoCos by rating at issuance for the years Overall, 48% of the AT1 CoCos (by number) and 57% of the T2 CoCos rated by Moody s received investment grade ratings at issuance. For both AT1 CoCos and T2 CoCos, a larger percentage of the Moody s-rated CoCos received an investment grade rating in than in (for AT1, 50% in vs. 41% in ; for T2, 96% in vs. 84% in ). Figure 3. Moody s Rating Distribution at Issuance for Tier 1 and Tier 2 CoCos, by Number of Securities, Notes and Sources: Data are from Moody s Investors Service, Moody s Quarterly Rated & Tracked CoCo Monitor Database Year End A (T2) Baa (T2) Ba - Caa (T2) A (AT1) Baa (AT1) Ba - Caa (AT1) 4

5 Recent Developments Disputed Exercise of Regulatory Call Provision In early, Lloyds announced that it might exercise its regulatory call option, as its ECNs were unlikely to count towards the minimum amount of capital required in future stress tests. 9 This announcement raised concerns amongst bondholders that the bonds, which were trading above par at that time, would be repurchased at par. 10 Lloyds ultimately offered to repurchase some of the ECNs from retail investors at prices above par, and to exchange others held by institutional investors for new capital instruments. 11 More than half of the Lloyds ECNs were repurchased or exchanged in early. 12 Later that year, Lloyds announced that it planned to seek permission from the Prudential Regulatory Authority (PRA) to call some of the remaining outstanding series of ECNs at par, 13 again raising concerns amongst bondholders. While Lloyds received permission from the PRA for the redemptions in March, the case was then referred to court for a declaratory judgment. 14 On 3 June, the High Court ruled against Lloyds plan to redeem the ECNs. 15 Lloyds appealed the decision and received approval on 10 December from the Court of Appeal to redeem the ECNs. 16 The U.K. Supreme Court began a hearing to review the Court of Appeal s decision on 21 March Several regulatory bodies have issued warnings in the last few years regarding sales of CoCos to retail investors. Further attempts by financial institutions to exercise regulatory call provisions may also result in disputes. Regulatory Scrutiny Several regulatory bodies have issued warnings in the last few years regarding sales of CoCos to retail investors. For example, on 31 July, the European Securities and Markets Authority issued a statement explaining the risks of investing in CoCos and stating that their analysis can only take place within the skill and resource set of knowledgeable institutional investors. 18 On 5 August, the UK s Financial Conduct Authority announced a temporary restriction on the distribution of CoCos to the mass retail market, effective 1 October to 1 October, 19 with final rules taking effect on 1 October. 20 On 1 October, Denmark s Financial Supervisory Authority warned financial institutions against selling CoCos to retail clients. 21 And on 15 October, Germany s Federal Financial Supervisory Authority stated that [i]n general, [CoCos] are not suitable for active distribution to retail clients. 22 CoCos have been reported to be popular with retail investors in Australia. 23 While the Australian Securities & Investments Commission (ASIC) provides explanations of the features and risks of CoCos on its investor education website, 24 the regulator has not restricted their sale. Regulators concerns regarding potential mis-selling of CoCos to retail investors could result in investigations and/or enforcement actions. Performance to Date The Bank of America Merrill Lynch Contingent Capital Index tracks the performance of CoCos. The Index had total returns of 5.8% in and 6.9% in. See Figure 4. However, even during this period, the performance of the Index was somewhat volatile, particularly in the second half of, a period when market participants were concerned about the financial condition of banks following the collapse of Portugal s Banco Espírito Santo that summer. 25 This coincided with the period during which several regulators issued warnings about the risks of CoCos. 5

6 Figure 4. Total Return on BofA Merrill Lynch Contingent Capital Index, 31 December March 2016 Concerns have been raised about banks ability to make discretionary coupon payments on AT1 CoCos. Total Return Index (31 Dec 13 = 100) Dec Jul Banco Popular Español postpones planned CoCo issuance citing poor market conditions. 26 Jun Bank of England issues warning about the risks of investing in CoCos. 31 Jul ESMA issues warning about the risks of investing in CoCos. 31 Mar 30 Jul Banco Espírito Santo posts 3.6 billion loss for the first half of the year. 31 Jun Notes and Sources: Data are from Factset and Factiva. 05 Aug UK Financial Conduct Authority announces a temporary restriction in the distribution of CoCos to the mass retail market. 1 Aug Bank of America Merrill Lynch announces will remove CoCos from global high-grade corporate and high-yield corporate indices. 30 Sep 01 Oct Danish Financial Supervisory Authority warns financial institutions against selling CoCos to retail clients. 15 Oct German Financial Supervisory Authority warns that CoCos are largely unsuitable for retail clients. 31 Dec 31 Mar 12-Jun UK Financial Conduct Authority confirms permanent ban on retail distribution of CoCos starting October 1,. 16 Dec Banks including Barclays, Royal Bank of Scotland and Lloyds Banking Group pass Bank of England stress test. 30 Jun 29-Dec Bank of Portugal imposes losses on Novo Banco senior creditors. 08 Feb 2016 Deutsche Bank attempts to reassure market about its ability to make upcoming coupon payments on CoCos. 30 Sep 31 Dec Events in late and early 2016 have reignited concerns about the financial strength of banks and the risks associated with their CoCos, with the Bank of America Merrill Lynch Contingent Capital Index declining by 10.6% between 31 December and 12 February 2016 (and declining by 2.6% year-to-date through 31 March 2016). In particular, concerns have been raised about banks ability to make discretionary coupon payments on AT1 CoCos, in the face of narrowing profit margins (due to, amongst other factors, weakness in commodities markets, negative interest rates, and slower global growth). 31 Mar 2016 Also, there have recently been new disclosures regarding the capital requirements European banks must meet before they can make payments on AT1 CoCos. On 16 December, the European Banking Authority (EBA) released an opinion that banks should ensure that they meet all of their capital requirements (including any bankspecific requirements imposed by regulators) when calculating the maximum distributable amounts for dividend and coupon payments on Tier 1 capital instruments. The EBA also recommended that regulators require banks to disclose all capital requirements relevant to the calculation of maximum distributable amounts. 26 While the European Central Bank (ECB) had initially wanted banks to keep their specific capital requirements confidential, 27 the ECB has since accepted the EBA s recommendation regarding the calculation of maximum distributable amounts. 28 During the Supervisory Review and Evaluation Process, some banking groups including, amongst others, UniCredit and BNP Paribas, disclosed their total capital needs for the first time under the ECB s harmonised framework

7 Recent actions have also underscored the risk of losses for bank creditors in a restructuring, even when those obligations rank senior to CoCos in the capital structure. On 29 December, the Bank of Portugal approved a re-transfer of liabilities from Novo Banco (the good bank that was formed as part of Banco Espírito Santo s restructuring) back to Banco Espírito Santo, imposing losses on some senior creditors. Further, on 1 January 2016, new bail-in rules went into effect in the European Union requiring banks to absorb losses equal to an amount not less than 8% of total liabilities including own funds of the institution under resolution (through write-down of those liabilities or otherwise) before any taxpayer support can be provided. 30 These events may have contributed to the recent performance of CoCos. Prices for several banks CoCos (e.g., Deutsche Bank, Santander, and UniCredit) dropped to their lowest levels ever in early February Despite a press release on 8 February 2016 asserting Deutsche Bank s ability to make upcoming coupon payments, Deutsche Bank s May EUR AT1 CoCo reached a low price of on 9 February Figure 5 shows the price performance of Deutsche Bank s May EUR AT1 CoCo issuance (blue line) and its common stock (gray line), both pegged to 100 as of 21 May. Figure 5. Deutsche Bank May EUR AT1 CoCo and Common Stock Price Performance and Correlation of Returns, 21 May 31 March 2016 Prices for several banks CoCos dropped to their lowest levels ever in early February Pegged Closing Price (EUR) Correlation of Returns May 21 Aug 21 Nov 21 Feb 21 May 21 Aug Notes and Sources: Data are from Bloomberg, L.P. and Factiva. Common stock and CoCo price series were pegged to 100 as of 21 May. DB Common Stock (Left axis) DB CoCo (Left axis) 60-day Correlation (Right axis) 21 Nov 21 Feb Correlation measures the degree of co-movement between two variables. The green line (using the right-hand axis) shows the observed trailing 60-day correlation between the price returns of the CoCo and the common stock. The trailing 60-day correlations ranged from 0.11 to 0.79, and were at their highest during periods when the common stock price had declined (for example, around December and September ). This is unsurprising, 7

8 as one would expect a CoCo to perform more like common stock as the size of the bank s capital cushion declines. Deutsche Bank s common stock price declined by 33.7% year-to-date through 31 March 2016, while the CoCo s price declined by 12.6%. In that same period, the trailing 60-day correlation between the securities returns increased from 0.38 to Potential Market Reaction to Missed Coupon Payment or Trigger Event To date, no CoCo has missed a coupon payment or has experienced a trigger event. Market participants use different methods to value CoCos. For example, a survey of CoCo investors by RBS found that the majority applied relative value analysis, comparing CoCos to other subordinated debt instruments. 31 However, some investors surveyed used more complex valuation models. When trying to model the likelihood of an extreme event, including a trigger event, there is the potential for modelling errors. To date, no CoCo has missed a coupon payment or has experienced a trigger event. Concerns have been raised regarding whether market participants are correctly assessing the risks associated with CoCos. It is possible that a missed coupon payment or a trigger event could affect valuations across the asset class. If investors suffer losses on their CoCo investments, it is possible that disputes between investors and issuers or distributors of these securities may result. Key Takeaways CoCos are novel hybrid financial instruments. While at issuance CoCos have debt-like characteristics (such as a specified coupon rate), they can convert to equity or have their principal written down upon a trigger event. Since 2009, banks have issued more than USD 380 billion of CoCos, with the majority of issuances coming from European and Asian banks. CoCos are more complex than most conventional debt instruments. Several regulatory bodies have issued warnings regarding sales of CoCos to retail investors. Prices for several banks CoCos dropped to their lowest levels ever in early February 2016, amid concerns about banks ability to make discretionary coupon payments. To date, no CoCo has missed a coupon payment or has experienced a trigger event. It is possible that a missed coupon payment or a trigger event could affect valuations across the asset class. While CoCo issuance stalled earlier this year due to the turmoil in the markets, UBS and Banco Bilbao Vizcaya Argentaria have recently come to market with new issuances of CoCos. As of the writing of this paper, it remains to be seen whether investor appetite for CoCos will continue to drive market growth at the pace observed in recent years. 8

9 Notes 1 For example, Moody s reports that 38% of CoCos issued in (by issuance amount) had an accounting-based trigger, 34% had a discretionary trigger, and the remaining 28% had both an accounting-based and a discretionary trigger. Moody s Quarterly CoCo Monitor: Issuance to be Flat in 2016 After 42% Drop in, Moody s Quarterly CoCo Monitor, 3 February 2016, p Data from Moody s Investors Service, Moody s Quarterly Rated & Tracked CoCo Monitor Database Year End (Excel Data). 3 CoCo Issuance Trails Pace Amid Challenging Market Conditions, Moody s Quarterly CoCo Monitor, 24 September, p George M. von Furstenberg, Bank Heal Thyself: Benefits of Adding CoCos to the Balance Sheet, CESifo Forum,, vol. 15, issue 3, pp , at p Moody s Quarterly CoCo Monitor: Issuance to be Flat in 2016 After 42% Drop in, Moody s Quarterly CoCo Monitor, 3 February 2016, p Rating Considerations for Contingent Capital Securities, Moody s Investors Service, February, 2010, pp Moody s: AT1 o clock, Bank+Insurance Hybrid Capital, July, available at: bihcapital.com//07/moodys-at1-oclock/, accessed 13 March Global Banks Rating Methodology, Moody s Investors Service, 31 May 2013, p. 2. Moody s: AT1 o clock, Bank+Insurance Hybrid Capital, July, available at: moodys-at1-oclock/, accessed 13 March Global Banks Rating Methodology, Moody s Investors Service, 16 July, p. 2. Moody s: AT1 o clock, Bank+Insurance Hybrid Capital, July, available at: moodys-at1-oclock/, accessed 13 March Events Brief of Preliminary 2013 Lloyds Banking Group PLC Earnings Conference Call (Fixed Income Investors) Final, CQ FD Disclosure, 13 February. 10 Aimee Donnellan, Lloyds ECNs tumble as investors prepare for the worst, Reuters News, 14 February. 11 Aimee Donnellan and Steve Slater, Refile-Updated 2-Lloyds offers bondholders olive branch with cash, exchange offer, Reuters News, 6 March. 12 Martin Arnold, Retail investors accept Lloyds offer to buy bail-in bonds, Financial Times, 17 April. 13 Nathan Collins, Stress test exclusion spurs Lloyds to exercise regulatory call on ECNs, GlobalCapital, 17 December. 14 Emma Dunkley, Lloyds retail investors take bond dispute to court, Financial Times, 31 March. 15 Emma Dunkley, Investor victory in Lloyds bank bonds challenge; Banks, Financial Times, 4 June. 16 George Hay, Lloyds strikes blow for edgy CoCo issuers, Reuters News, 10 December. 17 Jeremy Hodges, Third Round of Lloyds CoCo-Bond Fight Reaches U.K. Supreme Court, Bloomberg, 21 March ESMA Statement, Potential Risks Associated with Investing in Contingent Convertible Instruments, 31 July, p FCA press release, FCA restricts distribution of CoCos to retail investors, published 5 August, last modified 6 August, available at: accessed 13 March FCA press release, PS15/14: Restrictions on the retail distribution of regulatory capital instruments, published 12 June, last modified 12 June, available at: ps15-14-restrictions-retail-distribution-regulatory-capital-instruments, accessed 13 March Frances Schwartzkopff, Banks Warned on CoCo Sales to Retail Clients by Danish FSA, Bloomberg, 1 October. 22 BaFin, CoCo bonds: Risks for retail investors, 15 October, available at: EN/Fachartikel//fa_bj_1410_coco-bonds_en.html, accessed 13 March Vera Sprothen, Australian Investors Snap Up Risky CoCos; Individuals show enthusiasm for a security that many professionals steer clear of, The Wall Street Journal, 13 May. 24 For example, ASIC s MoneySmart website states that [c]apital notes, convertible preference shares and subordinated notes are complex investments. While they are issued by banks and insurers, they are very different to a savings account or term deposit. Available at: complex-investments/hybrid-securities-and-notes/bank-hybridsecurities, accessed 13 March On 30 July, Banco Espírito Santo posted a loss of 3.6 billion for the first half of the year, wiping out the company s capital buffer. On 4 August, the Bank of Portugal announced a bailout plan for Banco Espírito Santo. 26 European Banking Authority, Opinion of the European Banking Authority on the interaction of Pillar 1, Pillar 2 and combined buffer requirements and restrictions on distributions, 16 December, pp John Glover, CoCo Holders Need to Know Where the Tripwires Are, EBA Says, Bloomberg Business, published 25 January 2016, updated 26 January ECB, The Supervisory Review and Evaluation Process in, Maximum Distributable Amount section, available at: accessed 13 March UniCredit Press Release, UniCredit Group well above the specific capital requirements set by ECB, 10 December, available at: press-releases-price-sensitive//unicredit-group-well-abovethe-specific-capital-requirements-set.html, accessed 13 March BNP Paribas Press Release, SREP process completed: BNP Paribas capital ratio well above the 2016 minimum requirement from ECB, 23 December, available at: accessed 13 March Directive /59/EU of the European Parliament and of the Council of 15 May establishing a framework for the recovery and resolution of credit institutions and investment firms and amending Council Directive 82/891/EEC, and Directives 2001/24/EC, 2002/47/ EC, 2004/25/EC, 2005/56/EC, 2007/36/EC, 2011/35/EU, 2012/30/ EU, and 2013/36/EU, and Regulations (EU) No 1093/2010 and (EU) No 648/2012, of the European Parliament and of the Council [] OJ L173/190, art. 44 para. 5(a) and art. 130 para RBS, Cocos: Investors call for standardisation, more consistency, The Revolver, 12 May.

10 About the Author Erin McHugh is an Associate Director in the Securities and Finance Practice of NERA Economic Consulting, and manages projects in the areas of economics, finance, and valuation. She has consulted in litigation and arbitration matters in various venues, as well as in internal and regulatory investigations. Ms McHugh has worked extensively in the area of disputes between brokerage firms and customers concerning investments in equities, derivatives, fixed income, and structured finance securities. She has evaluated issues including the risk characteristics of the investments, suitability, concentration, and damages. Acknowledgements The author would like to thank NERA Chairman Dr Andrew Carron and NERA Managing Director Dr Chudozie Okongwu for valuable feedback on earlier drafts of this article, and NERA Analysts Marcin Pruski and Raphael Starr for research assistance. 10

11 About NERA NERA Economic Consulting ( is a global firm of experts dedicated to applying economic, finance, and quantitative principles to complex business and legal challenges. For over half a century, NERA s economists have been creating strategies, studies, reports, expert testimony, and policy recommendations for government authorities and the world s leading law firms and corporations. We bring academic rigor, objectivity, and real world industry experience to bear on issues arising from competition, regulation, public policy, strategy, finance, and litigation. NERA s clients value our ability to apply and communicate state-of-the-art approaches clearly and convincingly, our commitment to deliver unbiased findings, and our reputation for quality and independence. Our clients rely on the integrity and skills of our unparalleled team of economists and other experts backed by the resources and reliability of one of the world s largest economic consultancies. With its main office in New York City, NERA serves clients from more than 25 offices across North America, Europe, and Asia Pacific. Contact For further information and questions, please contact the author: Erin McHugh, CFA Associate Director erin.mchugh@nera.com The opinions expressed herein do not necessarily represent the views of NERA Economic Consulting or any other NERA consultant. Please do not cite without explicit permission from the author.