CoCo Bonds and their extension risk

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1 Aarhus University CoCo Bonds and their extension risk Jan De Spiegeleer (Jabre Capital Partners KU Leuven) Wim Schoutens (KU Leuven) 1

2 Aarhus University Extension Risk Aarhus Quant Factory January

3 Deutsche Bank: 5 years ago Aarhus Quant Factory January

4 Deutsche Bank: 5 years ago 4 DEUTSCHE BANK TIER 2 BOND Call Price= Sep08 17Dec08 16Jan09 27Feb09 The industry too often prices the bond up till the first call date Aarhus Quant Factory January

5 Extension Risk : 10 Yr NC bps Coupon Step-Up Aarhus Quant Factory January

6 Extension Risk : 10 Yr NC Price to Maturity Price to Call P Yield (%) Aarhus Quant Factory January

7 Extension Risk : Credit Spread Volatility Aarhus Quant Factory January

8 Extension Risk : 10 Yr NC Price to Maturity Price to Call 500 Rho Yield (%) Aarhus Quant Factory January

9 Extension Risk : 10 Yr NC5 9 Price to Maturity (Step Up = 100bps) Price to Maturity (Step Up = 200bps) Price to Maturity (No Step Up) Price to Call P Yield (%) Aarhus Quant Factory January

10 Aarhus University Contingent Convertibles Aarhus Quant Factory January

11 CoCos : Definition A CoCo bond is a loss-absorbing bond issued by a financial institution (bank or insurance company) that suffers either a conversion into equity or a write-down of its face value on the appearance of a trigger event. The loss absorbing mechanism is specified in the terms and conditions of the bond. 11! Lack! $ of standardization 50 bn issued in Europe! European banks mainly! Outspoken difference with bail-in capital 11

12 CoCos : Anatomy! Loss Absorption Mechanism! Trigger! Host 12 Event Instrument 12

13 CoCos : Anatomy! Loss Absorption Mechanism! Trigger! Host 13! Conversion in Shares Event Instrument! Write Down 13

14 CoCos : Anatomy 14 14

15 CoCos : Anatomy! Loss Absorption Mechanism! Trigger! Host Event Instrument 15! Conversion in Shares LossCoCo = N Cr S * S* = N (1 ) CP = N (1 ΠCoCo ) 15

16 CoCos : Anatomy! Loss Absorption Mechanism! Trigger! Host Event Instrument Conversion Price Mechanisms 16! Conversion in Shares LossCoCo = N Cr S * S* = N (1 ) CP = N (1 ΠCoCo )! Fixed Conversion Price Cp=αS0 Example : Lloyds 2009 (α=1), Barclays 2013 (α=2/3)! Floating Conversion Price Cp=S* Example : / Regulators oppose this idea! Floored Conversion Price Cp=max(S*,SF) SF=Floored Conversion Price Example : Credit Suisse 2011 CoCos 16

17 CoCos : Anatomy! Loss Absorption Mechanism! Trigger! Host! Write Event Instrument 17! Conversion LossCoCo = N Cr S * S* = N (1 ) CP = N (1 ΠCoCo ) Down Example! Full Write Down Example : KBC, Barclays in Shares! Write Down! Partial Full Write Down: ΠCoCo = 0! Staggered Staggered Write Down: Write Down Example : Rabobank (75% haircut) Write Down Example : ZKB Partial Write Down: ΠCoCo > 0 ΠCoCo = f(circumstances) 17

18 CoCos : Anatomy! Loss 18 Absorption Mechanism! Trigger Event Accounting Non-Viability / Regulatory! Host Instrument 18

19 CoCos : Anatomy 19 CET1 Trigger Level (%) Fully Loaded CET1 (%) Barclays Credit Suisse Accounting KBC Non-Viability / Regulatory Lloyds UBS ! Loss Absorption Mechanism! Trigger! Host Event Instrument March

20 CoCos : Anatomy! Loss Absorption Mechanism! Trigger Event Accounting Non-Viability / Regulatory! Host Instrument 20 The accouting trigger can be hit if Bank makes a loss which eats into the equity Regulator reviews the risk weighting of the assets Example: In June 2013, Denmark s FSA requested a review of Danske s IRB models, which results in a net increase of DKK100 billion (US$18 billion) or ~12.5% of group RWAs. In October 2013, the Ministry of Finance in Norway increased the LGD (loss given default) floors for residential mortgages. This has increased the riskweights 20

21 CoCos : Anatomy! Loss 21 Absorption Mechanism! Trigger Event The decision by the relevant authority to use public funds and inject these in the bank without which this bank would become non-viable. The decision by the same relevant authority that the bank is no longer viable without a write-off on its debt. Accounting Non-Viability / Regulatory! Host Instrument 21

22 CoCos : Anatomy! Loss Absorption Mechanism! Trigger! Host 22 Event Instrument Corporate Bond Callable Perpetual Fixed with Call Maturity Coupon Deferral Convertible Bond 22

23 Barclays : One Bank, Three Different CoCos ISIN Coupon Frequency Coupon Cancellation Maturity Face Value Currency Issue Date Issue Size (bn) Regulatory Treatment Callable Step Up Next Call Date Call Frequency CET Trigger Loss Absorption Conversion Price 23 US06740L8C27 US06739FHK03 US06738EAA Semi-Annual Semi-Annual Quarterly No 11/21/2022 No 4/10/ USD 11/21/ USD 4/10/ TIER 2 No Yes Perpetual 1000 USD 11/20/ TIER 2 Yes 2 TIER 1 Yes /10/2018 Onetime 12/15/2018 Every 5 Years 7.00% 7.00% 5.00% Full Write Down Full Write Down Equity Conversion 2.64 USD Extension Risk 23

24 CoCos : Investment Base (Regional) 24 Example : Barclays AT1 CoCo (issue date : December 2013) Switzerland 6% France/ Benelux 9% Asia 12% Southern Europe 6% UK/Ireland 53% US 14% 24

25 CoCos : Investment Base (Investor Type) 25 Example : Barclays AT1 CoCo (issue date : December 2013) Insurance/ Pension Funds 5% Banks 2% Other 2% Private Banks 9% Hedge Funds 21% Fund Managers 61% 25

26 Regulatory Framework 26 CoCos 26

27 Regulatory Framework 27 ADDITIONAL TIER 1 TIER 2! No maturity date! Subordinated! No incentives to redeem earlier! Senior! Can be callable after a minimum of 5 years! to senior debt to common equity and additional Tier 1 (AT1) Full discretion over coupon cancellability! Dividend! At stoppers are allowed least a non-viability trigger 27

28 Regulatory Framework Issuance of Contingent Capital in Europe 35 Additonal Tier 1 Tier 2 30 Issue Size ($ bn) Extension Risk Jan10 Jan11 Jan12 T Jan13 Dec13 28

29 CoCos : Several Layers of Risk 29 Loss Absorption 4.0% Extension Coupon 2.5% Coupon Cancellation Interest Rate Risk 29 29

30 Aarhus University Valuation of CoCo bonds 30

31 Market Implied Valuation : Two Approaches 31 Market Implied Models Credit Derivatives Method Equity Derivatives Method 31

32 Market Implied Valuation : Two Approaches 32 Market Implied Models Credit Derivatives Method Equity Derivatives Method 32

33 Models can be downloaded : 33 om 33

34 Valuation : Credit Derivatives Approach! Credit 34 Triangle : cs = λ x (1- Πbond)! Link between a credit spread (cs), recovery rate (π) and instantaneous default probability (λ)! The parameter (λ) is also called default intensity.! The probability to go default during a particular time T is : 1- exp(-λt) 34

35 Valuation : Credit Derivatives Approach CoCo Spread 35 S* (Implied Trigger Level)? 35 64

36 Valuation : Credit Derivatives Approach! Hitting S* can be modeled.! In a Black-Scholes world, the probability p* of hitting S* is : 36 36

37 Valuation : Credit Derivatives Approach 37 Rule of Thumb Pricing for a Credit Default Swap: Credit Spread = Expected Loss * Default Intensity cs = (1 πbond) * λdefault The expected loss is determined by the value of the shares (S*) when conversion takes place. The CoCo investor loses the face value of the bond (N), but receives Cr shares instead. (The conversion ratio Cr = N / Cp ). Expected Loss = N - Cr x S* Rule of Thumb Pricing for a CoCo Spread: CoCo spread = (1- Stock price at trigger S*/Conversion price Cp) x λtrigger CoCo spread = (1 πcoco) * λtrigger λtrigger log(1 p* ) = T 37

38 Valuation : Credit Derivatives Approach 38 Calculate Recovery Bond Π=S*/Cp Choose S* Coco spread Calculate p* Calculate λ (probability of hitting this barrier) 38

39 Valuation of CoCos: Credit Derivatives Approach 39 Implied Trigger level for Lloyds 39

40 Valuation of CoCos: Credit Derivatives Approach ISIN Coupon Frequency Coupon Cancellation Maturity Face Value Currency Issue Date Issue Size (bn) Regulatory Treatment Callable Step Up Next Call Date Call Frequency CET Trigger US06740L8C27 US06739FHK Semi-Annual Semi-Annual Loss Absorption Conversion Price Full Write Down No 11/21/ No 4/10/ USD 11/21/ USD 4/10/ TIER 2 No 1 TIER 2 Yes 683 4/10/2018 Onetime 7.00% 7.00% Full Write Down 40

41 Valuation of CoCos: Credit Derivatives Approach 41 Implied Trigger level for Barclays Barclays CoCo Bond US06740L8C Implied Trigger Levels are different? S /S ( %) Non Callable CoCo Callable 10Yr NC5 (priced till call date) 8 02 Jan Apr Jul Sep Dec 2013 T 41

42 Aarhus University Including Extension Risk Aarhus Quant Factory January

43 Including Extension Risk 43 cs C o C o (1) T cs c o C o T or T E Aarhus Quant Factory January

44 Including Extension Risk! Assume that CoCo Spread follows geometric Brownian Motion! Introduce 44 CoCo Spread Volatility : σcoco Coupon Step-Up at the call date ti = cx,i! Calculate the probability that bond is called at the different call dates! Calculate the expected Maturity Date TE Aarhus Quant Factory January

45 Including Extension Risk cs C o C o 45 T or T E Aarhus Quant Factory January

46 Including Extension Risk 46 cs C o C o (1) T cs c o C o (2) cs c o C o T E T or T E Aarhus Quant Factory January

47 Including Extension Risk (CallDate = April 2018) May Mar 2019 TE 28 Jan Nov Sep Aug Apr Jul Sep 2013 Aarhus Quant Factory January Dec

48 Including Extension Risk 48 Barclays CoCo Bond US06740L8C S /S ( %) Non Callable CoCo Callable 10Yr NC5 Callable 10Yr NC5 (with Extension Risk) 8 02 Jan Apr Jul Sep Dec 2013 T Aarhus Quant Factory January

49 Aarhus University Thank you

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