Guest Post by Len Santoro
Last year, European banks issued a record amount of a new type of high-risk bond meant to bolster each respective bank's Tier I capital in times of stress. This year Deutsche Bank, which has been suffering through a lengthy restructuring and extreme litigation and settlement costs, may have to tap these bonds - wiping investors out.
Deutsche Bank 6% Perpetual Contingent Convertible Bond Price Chart (Bloomberg)
These new bonds are called Contingent Convertible’s (“CoCo’s”). They are a pre-funded source of capital meant to insure that the issuing bank maintains its Tier 1 Capital ratio if its other assets decline in value.
If a bank's assets suffer a catastrophic decline in value, the CoCo's are triggered and the capital gets transferred to the bank's balance sheet when it needs it the most, without having to go through a protracted and costly capital raise.
CoCo's can be considered a form of insurance-linked securities ("ILS") that insure against financial catastrophies (see our previous posts on ILS here and here). CoCo's offer high yields, are highly complex, and can turn into equity or be written down to zero by the issuing banks at their discretion.
The creation and issuance of CoCo bonds goes back to the financial crisis of 2008-2009 which saw bank balance sheets destroyed by bad bets on sub-prime mortgages. The international banking community, working through the Basel accords has been required to bolster its Tier 1 Capital. CoCo bonds provide a buffer to an issuing bank's Tier 1 Capital. Just like a catastrophe bond, if the issuing bank takes large losses to it's capital base, the CoCo bond gets written down for its owners and the assets are transfered to the issuer's balance sheet.
In this way, it can be thought of as insurance for the banks Tier 1 Capital ratio.
Tier 1 Capital
Tier 1 capital is comprised of common stock, retained earnings, some types of preferred stock, and certain hybrid securities such as trust preferred securities and now, CoCo’s. It is used in the computation of a banks leverage ratio. This ratio is calculated by dividing Tier 1 capital by total assets.
Since the global financial crisis, regulators have been working with banks to raise their Tier I capital (and thus lower their leverage).
Contingent Convertible as Tier I Capital
To qualify as Tier 1 capital, CoCo’s must meet a number of criteria, some of which include them being:
- Not convertible at the holders option;
- Having interest deferability where the profitability of the bank would not support payment.
Essentially, a CoCo is constructed to absorb losses when the bank's capital drops below certain regulatory levels. Exactly how losses are absorbed varies by security and structure.
At issuance, CoCo’s are non-dilutive, debt servicing is subsidized by tax deductions, and, unlike traditional convertible securities, the issue is converted at the issuers discretion. CoCo’s frequently do not have a maturity date and are typically callable every five years. The other two key characteristics are the "trigger point" and the "lost absorption mechanism".
The Trigger Point
The trigger is the event that changes these securities from being contingent to certain. Like ILS, CoCo triggers are very specific and are defined in the prospectus. In practice, the trigger point is where the CoCo is partially or totally written down, or converted to stock.
Triggers can be formula- or regulatory-based and there are unique risks associated with each. Formula-based triggers can be based on book or market value. Book value triggers are less transparent and less timely.
Market value formula triggers have the advantage of being timely and transparent, however, they are subject to market pressures.
It's hard to imagine a situation where a trigger executed based on a regulator's decision would be preferred by the bondholder.
The Loss Absorption Mechanism
Loss absorption is simply the method through which management takes the bondholders investment.
There are two main methodologies for implementing this transfer of wealth. One is through equity conversion and the other is through an outright principal write down of the bondholder's investment. Historically the loss absorption method has been evenly split between the two methods.
On the surface, equity conversion appears to be a preferential method for bondholders. Having equity gives the bondholder some upside potential. In addition, since equity conversion is dilutive, one can assume that management will be less motivated to implement the trigger.
However, the second part of the equity conversion method is the conversion price. Depending on the issue, the conversion could be the market price at the time the trigger is breached or some other predetermined price. Since a market price conversion would be dilutive, that is the most favorable to the CoCo investor. A predetermined price conversion is less dilutive, and thus less attractive for bond investors.
Some CoCo's give the issuer the ability to write-down the bonds to zero if certain triggers are met. In this way, they are similar to Catastrophe Bonds that have been issued by reinsurers to protect issuers against severe weather events.
The principal write-down security is most attractive to the issuer since it is not dilutive to current shareholders. As with most bonds, what is favored by the issuer should be avoided by the bond investor. The danger of buying a principal write down CoCo with a "high " trigger is that the company can obtain cheap capital when the bank is still well above insolvency, all at the bondholder’s expense.
As a general rule, market price equity conversion with low triggers is most attractive while principal write-down with high triggers are the least. As with all fixed income investments, the bondholder must recognize that they and management are adversaries.
If a Coco bond write down is executed at a relatively high trigger point, it could be a windfall for the stockholders. In such a case, there would be a transfer of wealth from the bondholders to the stock holders when the bank is still far from insolvency.
CoCo’s have high complexity risk and are suitable only for the most sophisticated investors who are capable of understanding and evaluating their risks. To fully evaluate the risks of a CoCo bond, an investor (or advisor) would need to understand at least the following factors:
- Bank capital requirements and potential changes to those requirements;
- The effect of the investment on an overall portfolio
- Currency risks
- The terms and provisions of the security
- How economic and interest changes might affect the security
In the Deutsche Bank deal mentioned above, the prospectus states:
The Notes may not be a suitable investment for all investors. Potential investors must determine the suitability (either alone or with the help of a financial adviser) of an investment in the Notes in light of their own circumstances. In particular, each potential investor should:
have sufficient knowledge and experience to make a meaningful evaluation of the Notes, the merits and risks of investing in the Notes...
have access to, and knowledge of, appropriate analytic tools to evaluate, in the context of his/her particular financial situation, an investment in the notes...
have sufficient financial resources and liquidity to bear all of the risks of an investment in the Notes, including the risk not to receive any return on investment or repayment of the invested amount...
understand thoroughly the terms of the Notes and be familiar with the behavior of the financial markets; and
be able to evaluate possible scenarios for econmic, interest rate and other factors that may affect his/her investment and his/her ability to bear the applicable risks.
Clearly, CoCo's are only appropriace for the most sophisticated market participants. Furthermore, Deutsche Bank also attached a minimum lot size of the issue of $200,000, which demonstrates that it was not targeted for retail investors. (Most corporate bonds have $1,000 minimum lot sizes.)
In the current low interest rate environment, the mid-single digit percent yield on most CoCo’s is attractive. However, chasing yield in CoCo bonds could end badly, especially for investors who did not understand what they were sold.
CoCo’s are only appropriate for investors who are comfortable speculating with their investments and who are prepared to see their CoCo investment wiped out if the bank issuers comes under stress. As with all ILS, CoCo bonds should only be purchased in diversified pools and only represent a small portion of an investor’s diversified bond portfolio.
 John Glover, "Deutsche Bank's Woes Threaten CoCo Coupons, CreditSights Says", Bloomberg. Available at: http://www.bloomberg.com/news/articles/2016-02-08/deutsche-bank-s-woes-threaten-coco-coupons-creditsights-says; Accessed Tuesday, February 9, 2016. For general background on CoCos, see: John Glover, “Riskiest Bank Bond Sales Swell to Record in Europe”, Bloomberg, http://www.bloomberg.com/news/articles/2014-10-01/riskiest-coco-bonds-post-record-sales-in-europe-credit-markets (October 1, 2014)
 FDIC, “Optional Regulatory Capital Worksheet”, https://www.fdic.gov/news/news/inactivefinancial/1998/fil9833b.pdf
 Deutsche Bank Research, “Contingent Convertibles: Bank Bonds Take on a New Look”, May 23,2011, https://www.dbresearch.com/PROD/DBR_INTERNET_EN-PROD/PROD0000000000273597/Contingent+Convertibles%3A+Bank+bonds+take+on+a+new+.pdf
 Deutsche Bank 6% Perpetual Contingent Convertible prospectus, 8.
 . at 5.
 These yields are approximately three to four full percentage points over senior bank note bonds.
For information about insurance-linked securities expert Jack Duval, click here.