This post continues our series on insurance-liked securities ("ILS").
There has been a excessive amount of worry surrounding Deutsche Bank Contingent Convertible bonds ("CoCos") in the past week. (See our previous coverage here.) As the weak sister in the European banking community, Deutsche Bank has been the focus of bond selling and consternation, as well it should be. The bank's stock is trading lower than during the Global Financial Crisis.
Chart 1: Deutsche Bank Stock Price Chart from 1999
However, should anyone be surprised that Deutsche Bank's CoCo bonds have sold off? Absolutely not. Indeed, they have performed exactly as advertised.
So why the angst?
I believe it is another case of complexity risk. The CoCo bond structures are so complex that they have not been understood, even within the institutional investing community.
How could the sophisticated institutional investing community not understand a bond issuance? Days before the CoCo bond priced, Deutsche Bank issued a 44 page presentation to explain it's plans for strengthening it's balance sheet. I have extracted on page from that presentation below.
Chart 2: Deutsche Bank Explanation of "Comprehensively strengthening capital and leverage ratios for the longer-term"
In order to understand this slide, you need to have facility with the following concepts:
- CET1 Capital;
- CRD4 Capital Ratio;
- G-SIB additional buffer;
- Conservation buffer;
- CET1 Minimum Ratio;
- CRD4 Adjusted Ratio;
- Pru Val;
- How these items will change between issuance and 2019
Luckily, Deutsche Bank provided some footnotes to help investors understand at these regulatory items, for example:
Global systemically important banks buffer may vary between 1% and 3.5%… DB currently assessed in the 2% bucket. Alternatively, a buffer for macro-prudential and /or systemic risk of up to 5% can be set by EU member states. The higher of the G-SIB buffer and this systemic risk buffer is then applicable... (the 2019 Requirements) currently excludes the potential for a countercyclical buffer of up to 2.5%… (the Adjusted Ratio) comprises fully loaded CET1, plus all current eligible AT1 outstanding (under phase-in).
Trying to figure out EU member bank capital requirements may have led to investors taking their eye off the bond prospectus. The Deutsche Bank CoCo bond prospectus disclosed a number of red flags that should have put investors on notice about the speculative nature of the debt. Some of those include:
- The bonds were rated below investment grade by S&P (BB), Moody's (Ba3), and Fitch (BB+) at issuance (P.1,7);
- The interest payments are made (or not made) at the complete discretion of Deutsche Bank and "depend on the Issuers Available Distributable Items ("ADI")… ADI means: the profit at the end of the financial year... any profits carried forward... minus any losses carried forward, and any profits which are non-distributable pursuant to applicable law". (P.8) Thus, any hit to profits, whether from an economic slowdown, loan loses, or settlement/litigation costs from regulators or others, would put the interest payments in jeopardy;
- Principal write-downs if Deutsche Bank's Tier 1 capital ratio fell to below 5.125% (P.11);
- A reduction in liquidity of the Notes from any event that could result in a write-down (P.11);
- Adverse price affects from changes in the Issuers Common Equity Tier 1 Capital Ratio (P.11);
- No scheduled maturity date for the Notes and redemption at the sole discretion of the Issuer (P.11);
Insurance, not Bonds
Deutsche Bank's investors seem to be upset that the CoCo bonds have declined in value. They should not be. CoCo bonds are a form of insurance-linked security. By purchasing them, the bond holders have chosen to insure the bank's Tier 1 capital ratio.
Once this is understood, it becomes obvious how the bonds should trade. The principal is not the bond holders, it is the "insurers" (bond holders) reserves. If the insured event comes to be (Tier 1 capital declining below 5.125 percent), the reserves go to the insured.
An insurer would be willing to make this bet in perpetuity (while adjusting premiums along the way for changes in risk). The fact that CoCo holders are now complaining about their returns shows that they are not willing to make this bet over and over and that they didn't understand it to begin with.
Chart 3: Deutsche Bank 3.7% of 24, CoCo, and Common Equity Price Chart
It appears likely that the complexities of CoCos blinded buyers to the fact that they were entering the insurance business, and that they didn't know how to do proper underwriting.
CoCo bonds are only suitable for those who have the ability to underwrite insurance on complex financial entities and who understand the shifting sands of European bank regulation. (These two criteria probably eliminate the vast majority of CoCo owners.)
As most investors learn at some point: the market is an expensive place to get an education.
 Source: Bloomberg.
 Deutsche Bank Investor Relations website; Available at: https://www.db.com/ir/en/images/Capital_increase_19_May_2014.pdf; Accessed February 15, 2016.
 Deutsche Bank Undated Non-cumulative Fixed to Reset Rate Additional Tier 1 Notes of 2014 prospectus.
 The Economist, Deutsche Bank's unappetising cocos, February 13, 2016; Available at: http://www.economist.com/news/finance-and-economics/21692933-investors-are-reassessing-yet-another-complicated-financial; Accessed February 16, 2016.
 Source: Bloomberg.
For information about insurance-linked securities expert Jack Duval, click here.