Avoid Contingent Convertible Bonds: All The Qualities Of A Bond, Except Security

by: The Owl

Summary

Contingent Convertible Bonds were designed to address Too Big To Fail (TBTF) risks, providing additional capital to create a "firewall" against large banks' failures and avoid systemic crises.

While they serve the interests of the issuers and regulators quite well, they are unattractive securities for the purchaser or creditor, incorporating the worst of both debt and equity.

Investors should demand higher coupon rates for Contingent Convertible Bonds to compensate for the risk and limited upside, or avoid altogether.

Better alternatives to CoCos as TBTF firewalls already exist, with a better balance of interests between issuer and creditor, in the forms of preferred stock/preference shares.

"That man has all the qualities of a dog, except loyalty" -- Gore Vidal

Purpose:

Like the man who has all the qualities of a dog, except loyalty, Contingent Convertible Bonds (CCB) have all the qualities of a bond, except security. While these securities were developed to avoid the need for additional government bailouts, a laudable goal, and while they can presumably contribute to that goal, their design is unbalanced, heavily favoring the issuer (and the interests of the REFA community, see below) at the expense of the creditor. Specifically, this type of security favors excessively the issuers without providing an adequate return for the investor, due to their imbalanced structure of (generally) low return with high risk. They address the concerns and interests of the Regulators, Economists and Finance Academicians (the "REFA community"), who have played a strong role in designing on them and insisting on their use, while investing little apparent effort at making them attractive to creditors. This structural imbalance could be offset with discounted pricing or enhanced coupon rates, but those have not been generally offered to-date (with a couple of notable exceptions, see below). In addition, it appears to the author that the risks of these securities are inadequately described in some coverage of these securities to-date.

The purpose of this article is to offer potential buyers of these securities "the other side of the story," helping to balance an excessively positive coverage of these securities to this point. After providing some background, definitions and descriptions of who would be buying and selling these CCBs, the discussion focuses on the concerns about this security, which the author feels have not been sufficiently highlighted in the media coverage. Real examples are offered, of three types:

i) Securities having reasonably priced risk,

ii) Securities that have pricing inadequately covering risk, and

iii) An extreme example of mispriced risk, where the coupon does not compensate for very high risk.

Following the examples, an existing, better alternative to these types of securities is offered, which better balances the interests of regulators and issuers with the creditors. In turn, the author hopes that this may prompt a reconsideration of the best, most sustainable ways to address "Too Big to Fail," about which we are all justifiably concerned.

It is the view of the author that most creditors are taking far too much risk for far too little return in general (applying to CoCos and many other securities). While the author believes that many creditors are in a "low interest rate trance" and failing to take a hard look across all of their investments (especially credit instruments), it is beyond the scope of this article to review those many classes. Instead, this article will focus on only one type of credit instrument with a particularly unfavorable risk/reward profile.

Background:

Recently, the Regulators, Economists and Finance Academicians (the "REFA" community) have wrestled with the origins of the recent financial crisis; from this analysis, significant effort has been invested to identify structural approaches to avoid governments and taxpayers being needed to "bailout" Too Big to Fail (TBTF) institutions (also known as SIFIs, or Systematically Important Financial Institutions). A consensus formed quickly and broadly that there needs to be a more substantial assets (i.e., equity) to make more robust the "firewall" against bank failures; as a result, this more robust asset base will be there to cushion impairment of assets and moot the need for bailouts, required to prevent broader systemic damage to the functioning of the economy. This is especially critical for the SIFIs, whose failure could have a profound and immediate on the broader financial system, which would likely cause very substantial economic damage. In short, there needs to be more capital and less leverage in the banking system to reduce the risk. There appears to be universal agreement on this point (for the avoidance of doubt, the author strongly agrees with this consensus).

Those who worked to develop solutions to TBTF are an intelligent, hard-working, dedicated group who had the best intentions in developing both the approach and specifying them in Basel III. There is little argument about what is needed to be done; unfortunately, how to get it done is another matter. The specific tool developed to address this problem fell well short of achieving the goal, in the opinion of the author. This effort has resulted in the development of and recommendation to use a novel, but untested approach that involves the use of so-called Contingent Convertible Bonds, also known by the innocuous-sounding nickname of "CoCos" (sounds like a Teddy Bear one could cuddle with). In addition, the author uses the acronym CCB to designate these securities.

The current offerings, as described below, have a number of issues that accumulate to deliver exceptionally high risk, in some cases with secured credit-like coupons covering sub-junk-like risk. Their ability to stem a financial crisis is relatively clear, absorbing significant losses at low cost to the institution; as an example, a German newspaper trumpeted them as "The easy way to rescue banks." What is less clear is why anyone would buy most of those being offered, given their highly disadvantageous risk/reward profile. Using these securities only in limited amounts will moot their use as a firewall against TBTF. Once buyers see the unbalanced nature of the majority of these securities, I hope that the lack of buyers will induce the REFA community to develop more balanced alternatives, issuers to use more attractive coupons/terms or else utilize the better alternatives that already exist to insure against TBTF.

What are Contingent Convertible Bonds?

Contingent Convertible Bonds have been defined by some of the top experts in the field as:

I) A contingent convertible bond is a less common form of hybrid security that possesses both debt and equity investment properties. CoCo bonds initially function as a debt instrument, whereby the security pays out a coupon or "yield" to investors over its life span. Like other forms of hybrid capital, under certain conditions, the CoCo security will convert from debt to common equity, the lowest and riskiest position on the capital structure.

II) Contingent Convertibles (CoCos): The next generation of subordinated bonds? The term CoCo is used to describe a new type of convertible bond that is automatically converted into a predetermined amount of shares when a predefined trigger is breached. Since this type of bond is transformed into equity upon conversion, it would be available for further loss absorption, and therefore, satisfies the new regulatory requirements of hybrid capital instruments.

III) Contingent Convertible Debt: The term CoCo is a broad term used to describe debt securities that automatically convert into equity on the occurrence of specified events, hence their description as "contingent" instruments. If the contingency event does not occur, conversion will not be triggered and debt instruments will be redeemed at maturity, just as conventional debt instruments are redeemed. In general terms, the structure of these instruments is such that the occurrence of specific events, such as the equity capital ratio falling below 8% (author's note: or other percentages, 7% 5.5% or 5% being most common), will trigger a mechanism activating conversion of the debt into equity at a predetermined rate. The price and ratio of shares resulting from the debt conversion is determined ex ante.

Is it clear now? There appear to be many different versions of these securities, and not all are sufficiently well-defined or well-described to enable creditors to purchase them with an adequate understanding and confidence.

Who Would Purchase Contingent Convertible Bonds, and From Whom Would These Securities Be Purchased?

My expectation of a purchaser of CCBs would be those investors seeking additional return for additional risk who are very sophisticated credit and balance sheet analysts. There has not been much published on the demographics of who is actually buying these instruments, and what exists is a bit contradictory. One report indicated that there was "higher acceptance "of these instruments" by private banks and retail investors followed by asset management firms" and with "lower acceptance by hedge funds, banks and insurance firms." In a second report, however, individual (i.e., retail investors) will be barred from owning them in the UK, effective Oct. 1st, as will be discussed below. In that report, it was indicated that sales would be limited to "institutional, professional investors and high-net-worth individuals." Finally, there was one report of a $6B tranche of a Credit Suisse CCB being placed with two investors in the Middle East (Qatar Group and Olayan Group). This last example is in line with the author's expectation of who would be risking their capital on these securities.

These securities are very euro-centric, with 14 issuers of the 16 identified being European institutions (with 1 from Australia and 1 from South America). The Luxembourg Stock Exchange lists Convertible Contingent Bonds, having listed the early Credit Suisse 7.875% issue (ISIN: XS0595225318) in 2011. Presumably, they are traded on other exchanges and through the bank's trading desks as well.

Yet another report predicted a wave of CoCo issues being sold in NA. I did not find reference to any CCBs being sold (yet) from an NA institution. I believe that most of the additional capital raised has been in the form of additional common stock.

Concerns about Convertible Contingent Bonds:

I) Let's start with "These Securities Are Not Really Bonds": These bonds have all the qualities of a bond, except security. That is, while they are described as bonds, these securities are not really bonds as you know them, ought not be described as bonds when they are sold or, most importantly, will not act as a bond when it counts most, in a liquidation or distressed situation. It is only in distress that one determines the real safety built into a debt instrument. The ranking in the capital structure when in distress or during a liquidation, as well as the strength or weakness of the covenants, determines the level of safety of a specific security. In the case of distress or liquidation, these securities will likely have been converted into equity, with any protective covenants having been discarded, and being last in line for any recovery. As such, when previous articles have focused on the standing of the debt in the capital structure AS SOLD, this is highly misleading; during distress, the standing of this security (having been forcibly converted to equity) will be at the lowest rung on the seniority ladder. One of my strongest objections to the sale of these securities is how they are sold, as I believe some of these descriptions are very misleading.

II) They are Unattractive Equity as Well: These securities combine the worst features of both types of both debt and equity securities with pricing; other than a few exceptions, that does not cover the high risks of these securities.

a. While the common equity can grow, CoCos will not as they are bonds "when it is not important." During the good times, one can experience capital growth, but these will not. Heads I stay flat, tails I lose (probably most of my investment) if "triggered" to buffer a crisis. Growth of capital represents about 60% of gains in common equity, with the remaining return coming from dividends, on average. However, only the coupon will provide return for the bond, without the security of a bond, but rather the risk of an equity. We can argue the average return of a share of common equity (in general, for banks, for financial companies), but to carry the risk of an equity in effect, the coupon would need to be in the 8%-9% range to provide a comparable, average equity return. Few CoCos are offering this level of coupon; as such, the thesis of this article is that CoCo purchasers are not capturing an adequate (equity) return for the (equity) risk they are taking.

b. Common equity can also experience increasing dividends over time. This advantage is also not afforded these securities. Of course, dividends can go down, and would do so with some level of distress, but that could also negatively affect the bonds as well (once triggered, dollar-for-dollar with the common equity).

c. As a common shareholder, one has a pro rata ability to influence management and vote for or against significant proposals. Owners of the Contingent Convertible Bonds do not typically have this right (until it is too late, when you have been converted to equity).

d. As soon as the bonds are triggered, these securities will incur, pro rata, the first dollar of loss, alongside the equity (which it now is). We will contrast that to preferred shareholdings later.

III) Triggering Mechanisms are Unclear: In some cases, there are unclear, unstandardized or arbitrary mechanisms for triggering these securities, as described in "Contingent convertible bonds and the impact of Basel III" by Alix Prentice, Angus Duncan and Antoinette Maginness:

"There has been criticism of each of these (triggering) mechanisms:

  1. In relation to capital triggers that rely on accounting measures, criticism has focused on their inherent delay in responding to a financial crisis. Financial reporting takes place on a quarterly basis, which means that the trigger will only be capable of occurring at the end of an accounting period, and in some instances, this may prove too late for a CoCo to perform its primary function: to act as an effective loss-absorber;
  2. Regulatory-based measures may lead to ad hoc decisions, thus creating uncertainty for investors. The fact that the discretion is exercised by regulatory authorities will make it difficult for investors and rating agencies to assess the probability of conversion taking place; and
  3. Market-based triggers, such as share price, would be subject to stock market volatility and stock price manipulation. In addition, a market-based trigger may be affected by many market events unconnected to the financial health of the bank in question.

    Many commentators suggest that a dual trigger mechanism is a suitable compromise; for example, one that relies on accounting measures coupled with regulatory discretion."

In my opinion, a dual trigger mechanism would only compound the problem, but that is not the most important point. The only quantitative trigger is the first variety, with the other two being highly subjective. This discussion should leave the reader with a real concern that these instruments are being sold currently without solid, high-integrity mechanisms developed to identify when these conversions should be appropriately "triggered," with significantly negative financial consequences for the holder when they occur. I am also concerned that those triggering them will have much more incentive to trigger early than to maintain a disciplined approach. A description of a triggering mechanism as an "ad hoc decision" is hardly inspiring confidence to rush out and buy these securities, and holders of these securities will be at the mercy of those required to make subjective judgments.

IV) They Carry Duration Risk: Basel III has encouraged these securities to be a minimum of 5 years; in fact, some have longer durations and others are perpetual securities. As such, they not only carry a super-charged credit risk, due to their low priority once converted to equity, but also carry significant interest rate risk.

V) Effective Oct. 1st, the UK regulator will bar individuals from owning these securities. At least one regulator is awake at his post. From this action, one can infer the viability of this type of security. Other types of equities or preferred/preference shares are freely traded by individuals, which could substitute for these securities. "In a low interest rate environment, many investors might be tempted by CoCos offering high headline returns," Christopher Woolard, the FCA's director of policy, risk and research, said in a statement today. "However, they are complex and can be highly risky." The reader can infer from this that there are some concerns that they are too risky or too complicated or both for most investors. This should raise a red flag about their advisability for anyone.

VI) These are incredibly complicated securities, even if well-defined. Our recent history with complicated securities, which resulted in the trading of securities not well-understood by many practitioners and traders, did not end well. Securitization of sub-prime mortgages resulted in a problem needing to be solved by another type of an incredibly complex security? Is this really the solution? I vote "No" on this one.

VII) The extreme complexity of these securities has one positive side effect. There have been some beautiful mathematics used to calculate approximate risk and returns that are (honestly, with no sarcasm intended) wondrous to behold (A, B). Simultaneous solutions of differential equations and Black-Scholes calculations that were indeed impressive. Two comments:

a. Are the owners of these securities prepared to master this level of mathematics? When was the last time that you solved a differential equations problem? Can you remember what a Laplace transform is?

b. The models employed or inferred, not surprisingly, Black-Scholes calculations, which has at its core a dependence on normal distributions or "common cause variability." These are useful in calculating the minimum or normal risk, but the real risk to these securities is the "special cause" failure, which falls, by definition, outside of the normal distribution. These events are referred to commonly in financial publications by the term popularized by Nicolas Nassim Taleb as "black swan" events. I prefer the more descriptive term "special cause," which was learned from Product Quality Manuals developed by Brian Joiner. Normal distributions or "common cause" distributions do not predict or represent the disruptive events caused by a sudden, significant change of the premise on which those normal distributions are based. The academic models and publications, as beautifully created as they are, calculate only the minimum risk encountered; the average or maximum risk is incalculable, as special cause is not well-estimated by mathematics (by definition) from the existing "common cause" or normal distribution.

VIII) These securities capture all of the downside. Any special cause upside is not captured for the CoCo holder, and will flow to the equityholder.

Indeed, these securities have all the qualities of a dog, except loyalty.

Description & Examples of Convertible Contingent Bonds:

I) Rabobank: Actually, the first example of a Convertible Contingent Bond is one (actually two) that I would purchase to show that the author is not completely dogmatic on the issue. Why would I buy it?

a. This is a very well-run, stable bank, being an unlisted, private sector bank with a AAA rating and 14% Equity Capital Ratio2. I would own equity, if it were available, but it is a mutually owned bank. I am comfortable owning the CoCo at the right coupon.

b. It has the right coupon, with two tranches sold at 8.4% and 8.375% (listed in the Netherlands: no ISIN numbers provided). This are two of the few CoCos offering an equity-like return in the coupon. The 8.4% bonds were sold at a 5.5% spread over the current (at that time, Nov 2011) senior unsecured bond coupon rate. In the view of the author, the spread combined with a substantial capitalization of the issuer makes this return worth the risk. (I would probably take a pass on the other Rabobank tranche priced at 6.875% at a spread less than 4%.)

II) Another acceptable CoCo: Credit Suisse issued a "Tier 2 BCN", a high-quality credit with a relatively high coupon of 7.875% (ISIN: XS0595225318), which trades on the Luxembourg Stock Exchange. I would also consider such a credit, given the substantial buffers required for the Swiss banks with the so-called "Swiss Finish" to provide additional protection beyond that required by Basel III. Compare this to the UBS Preferred D series, from a similar issuer under similar regulation, with a variable coupon of Libor plus 0.7%. In effect, one gets a 7% spread to cover both the increase in credit risk and duration risk. Arguably, the 7% spread provides a reasonable recovery for the risk taken, and provides a near-equity-like return. This probably explains the ability to place $6B of like securities prior to this sale, as reported above.

The characteristics for those CoCos that could be considered for purchase: very high-quality banks and very high coupons (i.e., delivering equity-like total returns in the coupon), with both elements being essential for purchase.

III) Banco Santander: I also have the greatest of respect for the management of Banco Santander, but I have no idea why anyone would buy the recent issue of CoCos at 6.5% and 6.35%, when you can own the equity (comparable risk) with a 6.5% dividend yield, plus the possibility of capital gains and dividend increases; alternatively, compare these CoCos versus the preferred shares having dividend yields at or higher than the CoCo (SAN-A: 6.59%, SAN-C: 6.28%, SAN-F (fixed to floating): 9.98%, and SAN-I: 6.33%), and will be senior to the equity (resulting from forced conversion of the CoCo) if there is a distressed situation. Additionally, there exists a floating rate preferred (SAN-B:4.95%) which is at only 1.4%-1.55% below the fixed rate of the CoCo, which would offset the interest rate or duration risk of the CoCo (this would actually be my choice), as well as the seniority risk. This is not a comment so much about Banco Santander as a bank, but about the pricing and positioning of the CoCo versus existing alternatives from the identical issuer. This is a clear example where I believe that the creditors are not being compensated for the risk and disadvantageous structure of the CoCo. Quite simply, this is moderately mispriced risk.

IV) Bank of Cyprus: You really cannot make this up.

In April 2011, the Bank of Cyprus offered €1,342,422.297 of perpetual Convertible Enhanced Capital Securities ("CECS") to existing shareholders in the ratio of €3 CECS for every 2 shares held. The coupon was set at an initial fixed rate of 6.5% until 30 June 2016, and thereafter, at a floating rate of Euribor plus 3 per cent.

Perpetual, fixed rate sold at 6.25%, converting to variable rate, Euribor plus 3%, to insure the thin veneer of "riskless" Greek sovereign debt or whatever is owned by the bank at this point.

Here is a headline from March 30, 2013:

Bank of Cyprus big savers to lose up to 60 percent {of their deposits}

(and the remaining 40% was frozen)

This is the bank that was required by European Regulators to give huge haircuts to depositors (in my opinion, the "mortal sin of banking"), and now proposes that one would risk 100% of capital for 3% over Euribor for a thinly capitalized bank with shaky assets, being targeted by European Regulators?

Are you as a creditor going to insure society against this bank at 3% plus Euribor?

This is an example of extremely mispriced risk. You do not need yield this badly, even in this environment. Avoid it and securities like it.

A Better Alternative:

I) Preferred stock is a much better alternative to the CoCo structure for the creditor, and does not pose obvious disadvantages to the issuer. First of all, one doesn't need to solve simultaneous differential equations to estimate either risk or return. In addition, as the preferred shares are senior to common equity, the distressed situation would have to be so severe to deplete the book underlying the equity prior to the first penny of impairment being incurred for the preferred shares. These shares are typically very liquid, trading in substantial volumes. While they share some of the disadvantages of CoCos (no capital gain, no increase in dividend), as noted above, they are senior to common, but sometimes offer (as we have seen) the identical dividend/coupon. These can be called on to provide more capital as a firewall against failure (e.g., Lehman shares were taken out in that collapse); as such, I am at a total loss (pardon the pun) why the REFA community did not employ these securities in lieu of CoCos to provide the TBTF buffers necessary.

In some cases, a second "better alternative" exists:

II) Simply buy the common: If CoCos provide essentially no more security than the common to which it will be converted "when it counts," why not simply buy (issuer can sell) more common equity. The common has the advantages of capital growth, growth of dividends, ability to influence management through voting for board members and important initiatives, while maintaining a cleaner, simpler balance sheet. In NA, it appears that some banks simply addressed the equity concern by issuing significantly more equity. While it diluted the existing shareholders, it helped to maintain a clean, more clearly understood balance sheet.

A buyer could even employ a straddle (a different kind, with apologies to my options colleagues), with both some preferreds and some common being bought, the combination of which would provide better risk/reward balance than that of the CoCo. This can be made especially clear by doing the experiment with the Banco Santander securities described above.

Summary:

There are no bad securities, just bad prices. Almost every security reaches an equilibrium of fair value at some price or at some rate of return, and this should includes CoCos. However, these securities, representing the worst of both debt and equity, along with an extreme disadvantage of vague definition and arbitrary triggering mechanisms plus a variety of other problems, will need coupons that will exceed what issuers will want to pay in order to fairly compensate creditors for their risk. They need to be providing equity-return coupons of 8%-9%, and most are not offering that level of return. The author has indicated an openness to purchase selected issues of this security, but strongly recommends avoiding most issues of this security, as the return does not provide sufficient compensation for the risk. Fortunately, there exist liquid securities, traded today in high volumes, which can provide a better risk/reward profile for the purchaser and could provide the necessary "firewall" against TBTF crises.

I encourage my fellow creditors to not settle for mediocre and not reach for yield failing to cover risks, as a general statement; in this specific case, I urge my fellow creditors to avoid these securities, unless they can see coupons that will clearly cover the many risks embedded in the structure of this security. Just because society needs financial insurance to protect against the next TBTF event does not mean that you have to step forward to fill that role, short of getting a fair deal and a fair return. Purchase selectively, and only where you see balanced risk/reward.

I encourage those in the REFA community to rethink their unjustified support of these instruments and consider use of simpler, more liquid instruments like preferred stocks (preferably floating rate to address interest rate risk as well) to provide the "firewall" to prevent a future crisis. These approaches will provide equal protection, while also affording the buyer a fair chance to make a decent return. As a result, a more stable, sustainable financial system will emerge with more distributed assumption of risk and clearer management of resolution when the next bank run or crisis occurs, as it surely will.

Disclosure: The author is long UBS Preferred D shares.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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