Under the Swiss finish, Swiss banks must hold common equity tier 1 equivalent to 10% of their risk-weighted assets (RWA) – 3% of this can be in the form of high-strike contingent convertibles (CoCos) and 6% as low-strike instruments.
UBS tested the market with a tier 2 note – or low-strike deal – in mid-February. The bank stated that it would not be issuing high-trigger CoCos, preferring to use common equity capital for this 3%. The $2 billion dollar-denominated 10-year non-call five trade has a trigger of 5%, with loss absorption in the form of permanent write-down – probably a key test of appetite for new-style tier 2 risk.
UBS stated it plans to hold roughly 0.7% of RWA (SFr2.4 billion, or $2.7 billion) in contingent capital by the end of 2012 – potentially rising to SFr5 billion by the end of 2013.
"With a lower-level trigger, there is a lower risk of the trigger being tripped but there is a higher severity of loss with permanent write-down," says Thibaut Adam, head of capital markets structuring at bookrunner BNP Paribas. "This is a less-attractive proposition compared with equity conversion."
The consensus in the market seems to be that while permanent write-down would not work for a high-trigger product, it should be acceptable at the right price of a low-trigger instrument that is closer to a gone-concern product.
So what is the right price? The UBS trade priced at 7.25% and traded marginally below par on the break. But when Moody’s published a report the following day suggesting UBS could be downgraded by three notches, the bonds slumped by three points.
They recovered to nearly par by March 16, and by March 26 were trading at 98.67. But this is hardly the reception the bank must have been looking for.
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| UBS’s dollar-denominated 10-year non-call five trade with a |
Some in the market have criticized UBS for marketing the deal as a tier 2 product with contractual write-down rather than as a CoCo to tap into the traditional tier 2 investor base.
"To be fair, that’s what it was," says one banker away from the deal. "But there is a very small universe of institutional buyers that are happy to take permanent write-down, so this type of risk has to go to private banks and retail investors [a more volatile investor constituency]."
Credit Suisse completed its high-strike issuance with a SFr700 million deal in mid-March, Again, a 10-year non-call five, the deal incorporated equity conversion at a 7% capital ratio trigger and was increased from SFr250 million. Self-led, it priced at 7.125%, or 668.5 basis points over mid-swaps. By late March, the Credit Suisse deal was trading in the low 8s while the UBS deal was trading in the mid-7s – indicating that the UBS trade has gained no benefit from its low trigger.
These two trades are so different it is hard to draw parallels from them, but they do illustrate the continued unpredictability of the investor base for CoCos.
"For many institutional investors, the conversion option is difficult to deal with because they usually have a fixed-income mandate," says Adam at BNP Paribas. "So in a perverse way, permanent write-down is easier for them to deal with, even though they are economically worse off."
Credit Suisse will be coming to the market at some point with a low-strike deal and will be studying the implications of the UBS experience.
"Permanent loss absorption potentially sets up a different incentive structure for the issuer and its shareholders. Equity conversion, in most circumstances, incentivizes shareholders to avoid the trigger and the subsequent dilution. A low-trigger Credit Suisse deal with equity conversion would come at a much-tighter level than the UBS deal did," says one hybrid specialist.
