News that the EBA has sanctioned the issue of contingent convertible (CoCo) bonds by European banks to meet their core tier 1 capital requirements was confirmed yesterday as the authority announced that banks still need to find €115 billion of capital by June next year. The EBA will treat CoCos as additional hybrid tier 1 capital. The trigger point will be 7% of core tier 1.
The EBA has decided to accept cocos “under very strict and fully harmonised criteria”. Debate continues to rage over the suitability of a regulatory trigger rather than a market-based one but the bigger question is investor appetite for the instruments. As additional tier 1 they will be perpetual and will not include a coupon step-up. This will be a very hard sell to fixed income investors particularly for CoCos from weaker European banks.
Jan de Spiegeleer, head of risk management at Geneva-based Jabre Capital, reckons that the maximum volume of cocos that can be issued by the top 30 banks in Europe is €150 billion – far short of the €1 trillion that was being predicted for this market initially. He says that pricing models fail to adequately reflect the true risk that CoCos embody particularly as they approach the trigger. There is a danger for issuers, little discussed in the market to date, is that CoCo investors, by hedging in the equity market the risk of being converted into bank shares at the worst time to own them, may set off a downward spiral that destabilizes the institution.
“Pricing models do not take sufficient account of the negative convexity they embody,” he explained at a recent seminar. “CoCos are convertible bonds that are busted – they are that part of the convertible that you don’t want to own. The more the share price falls the more the holder of the coco bond is exposed to the share price. When you are close to the death spiral it becomes very hard to trade.”
This should concern banks considering the issue of CoCos to boost capital ratios. De Spiegeleer has studied the behaviour of convertibles that include a reset feature whereby the conversion ratio increases as the share price falls. He points out that investors will sell shares as the conversion ratio resets, leading to a death spiral and says that the same risks are at work with a CoCo.
“CoCos are a fat tail risk for which you are being compensated by a high coupon. The closer you get to maturity the more shares you will have to sell to hedge the CoCo which kills the share price,” he explains. “An instrument with a negative convexity overhang is a convertible that kills the stock price. If there is a big imbalance between the coco and the size of your free float of shares in the market it is going to pull your shares into a death spiral.”
De Spiegeleer points to the share performance of two coco issuers, Credit Suisse and Lloyds. Year to date Credit Suisse’s coco bonds are down 11.41% while its share price has fallen 52.97%. Lloyds has seen its cocos fall 15.37% and its share price 62.86%. There are probably many factors at play behind these banks’ share price declines, including the unfortunate ill-health of Lloyds’ new chief executive. The possibility that CoCos may contribute to a decline in share prices that then induces further concern among coco investors in a classic negative feedback loop deserves close study.
European banks considering cocos need to be aware of the cliff risk associated with having the fate of large deals glued to a single event – such as a 7% core tier one trigger. De Spiegeleer suggests that this can be mitigated by issuing a series of cocos at different triggers rather than a single, large deal. “You can limit the death spiral by doing multiple issues across the different core tier 1 ratios,” he says. “If you have multiple cocos with different trigger levels there is a dampening effect and hedgability is a lot better.“
