'Contingent Convertibles' The World of CoCos

Transcription

1 February 2014 'Contingent Convertibles' The World of CoCos Jan De Spiegeleer & Wim Schoutens February 2014 Reacfin's 10th anniversary event

2 Outline 2 Introduction (Wim) n Contingent Capital Quantitative Side of CoCos (Wim) n Anatomy of CoCos n The life of a CoCo n Modelling CoCos n Pro s and con s n Issuers and investors Regulatory Aspects (Jan) Risk Management of CoCos (Jan) n Basel III and CRD4 n New instruments, new risks. n Bail in vs CoCos n The Death-Spiral effect n Extension Risk

3 Introduction 3 A Contingent Convertible (CoCo) bond is a debt instrument that converts into equity or writes down as soon as the banks gets into a life threatening situation. Conversion/write down happens via a predefined trigger mechanism: e.g. Common Equity Tier-1 (CET1) falling below 7% and is often accompanied with a regulatory trigger. For CoCos with a conversion feature, this creates dilution for existing shareholders, but protects potentially taxpayers.

4 What is a CoCo? 4 In the aftermath of the financial crisis Contingent Capital solutions were proposed to strengthen bank s Additional Tier 1 (AT1) and Tier 2 (T2) capital levels. CoCos are such AT1 or T2 instruments and are situated in the hybrids area of the balance sheet in between equity and traditional debt. Under the new EU Capital Requirements Directive (CRD4), all new AT1 capital needs to have CoCo features.

5 What is a CoCo? 5 n CoCos are issued as bonds, but the more the bank is in trouble, the more CoCos start behaving as equity. n How to model it: as fixed income or as equity? n How to threat it : as a child or and adult?

6 What is a CoCo? 6 n CoCos are issued as bonds, but the more the bank is in trouble, the more CoCos start behaving as equity. n How to model it: as fixed income or as equity? n How to threat it : as a child or and adult? Like teenagers, they spend many hours in their bedrooms, suspiciously quiet, you never knowing what they are up to, and then suddenly there s an outburst of sound and fury, the cause of which you never understand. Hybrid instruments and teenagers are both to be treated with love and understanding. Paul Wilmott

7 The Life of a CoCo 7 Regulatory Trigger C C DISTRESS Bondholder becomes Shareholder or Bond is (partially) written down Core Tier 1 Trigger ISSUE C C C C C C C C C REDEMPTION Coupon Payments NEW ISSUE

8 CoCos Payoff Profile 8 Payoff Profile small probability of an extreme high loss Probability Gain Loss

9 Introduction: CoCos Nature 9 Difference with convertible bonds High coupons Unlimited Downside (No Bond Floor) Limited Upside (Bond Ceiling) Negative convexity

10 Major Outstanding European CoCos (Feb/2014) 10 10

11 CoCo Yield Breakdown 11 Interest component: in the present low interest rate environment rather small. Liquidity component: CoCos are new asset class with only relative liquidity and a still a lot of regulatory uncertainty and model uncertainty. Extension risk component: Most CocCs are callable bonds. However most of the time no step-up is present/ allowed. Coupon cancellation risk: For some CoCos (T1) coupons are cancellable at the discretion of the issuer/ regulator. They are typically non cumulative. Conversion component: compensates for the event that the CoCo bond is converted into equities or reduced in value. Optional Conversion component: reduces because of the right of the investor to participate in the positive performance of the underlying shares (CoCoCo only).

12 CoCo Yield Breakdown 12 Interest component: in the present low interest rate environment rather small. Liquidity component: CoCos are new asset class with only relative liquidity and a still a lot of regulatory uncertainty and model uncertainty. Extension risk component: Most CocCs are callable bonds. However most of the time no step-up is present/ allowed bp bp bp Coupon cancellation risk: For some CoCos (T1) coupons are cancellable at the discretion of the issuer/ regulator. They are typically non cumulative. Conversion component: compensates for the event that the CoCo bond is converted into equities or reduced in value bp Optional Conversion component: reduces because of the right of the investor to participate in the positive performance of the underlying shares (CoCoCo only).

13 CoCo Yield Breakdown 13 On average, CoCos offer a 4 times spread pickup over senior, or over 400 basis points in absolute terms.

14 Who buys CoCos? 14 n Asset Managers: Have the expertise and have previously been exposed to hybrid instruments (pre-2008). Have large existing holdings in T1-T2 products. There have been some recent launches of CoCo funds. n Hedge Funds Have more risk-appetite and have the experience to hedge to some extend the unwanted risks away. n Insurance Industry Solvency II favors short dated, high rated debt. This is opposite to what CoCos stand for. However the extra yield is often attractive. n Employees Some investment banks (Barcap, CS) pay CoCo bonuses to their top-management. 14

15 CoCo Issuance European Contingent Convertible Issuance CoCo Bonds CoCo Bonds (Write Down) CoCo Bonds (Equity Conversion) USD (bn) Dec 09 Dec 10 Jan 12 Jan 13 Feb 14 T

16 CoCo Issuance : Lloyds (December 2009) European Contingent Convertible Issuance CoCo Bonds CoCo Bonds (Write Down) CoCo Bonds (Equity Conversion) USD (bn) Dec 09 Dec 10 Jan 12 Jan 13 Feb 14 T its worth a try Mervin King Governor Bank of England

17 CoCo Issuance : Swiss Finish European Contingent Convertible Issuance CoCo Bonds CoCo Bonds (Write Down) CoCo Bonds (Equity Conversion) USD (bn) Dec 09 Dec 10 Jan 12 Jan 13 Feb 14 T A finishing school (or charm school) is a private school for girls that emphasizes training in cultural and social activities. The name reflects that it follows on from ordinary school and is intended to complete the educational experience, with and emphasis on etiquette. CoCos are the finishing touch in the strengthening of the capital of the Swiss banks.

18 CoCo Issuance : Lloyds (December 2009) European Contingent Convertible Issuance CoCo Bonds CoCo Bonds (Write Down) CoCo Bonds (Equity Conversion) USD (bn) Dec 09 Dec 10 Jan 12 Jan 13 Feb 14 T Write Down CoCo bonds outnumber Equity Conversion CoCos

19 CoCos Pros and Cons 19 Can they save the banking system? þ extra buffer þ clear upfront conditions þ no taxpayer money at stake þ coco-bonus þ... Caveats : n if held by financial institutions, no reduction of systemic risk n death spiral n can work too slow n...

20 Regulatory Aspects 20

21 Avoiding the use of tax payers money BASEL III 21 Avoiding the use of tax payers money Make bank failure less disruptive Make bank failure less likely Resolution Authority Living Wills Make banks less volatile Make bank debt loss absorbing Dodd Frank Ring Fencing Central Clearing Contingent Capital Bail-In Capital

22 Basel III world : CoCo Friendly 22 n Regulatory Capital needs to be loss absorbing n CoCo Bonds are allowed in the capital structure 2% Tier 2 1.5% Additional Tier % Trigger Discretionary Coupons Perpetual with no incentive to redeem early Callable after 5 year Subordinated Regulatory trigger (Point-of non-viability) n Leverage Ratio Calculations n ECB s comprehensive assessment (2014)

23 CoCos and the ECB s comprehensive assessment (2014) 23 Risk Assessment Liquidity Funding Leverage Asset Quality Review Stress test Baseline Scenario Adverse Scenario

24 CoCos and the ECB s comprehensive assessment (2014) 24 Risk Assessment Liquidity Funding Leverage Asset Quality Review Stress test Baseline Scenario (8% CET1) Adverse Scenario (5.5% CET1) CoCos can be used to offset the capital shortfall. The caveat is here the fact that the AT1 CoCo bonds have their trigger set at 5.125%. They therefore cannot be put at work in the stress tests.

25 Basel III world : CoCo Friendly Issuance of Contingent Capital in Europe Additonal Tier 1 Tier 2 25 Issue Size ($ bn) Jan10 Jan11 Jan12 Jan13 Dec13 T The main focus of the European banks since Q was on the issuance of AT1-CoCo Bonds 25

26 Basel III world : CoCo Un-Friendly 26 n CoCo Bonds are not-allowed to deal with the extra capital imposed on globally systematic important institutions (G-Sibs)

27 Will CoCo s Trigger? 27 Counter Cyclical Buffer Capital Conservation Buffer Core Equity

28 Will CoCo s Trigger? 28 Counter Cyclical Buffer % CoCo Trigger will recapitalize the bank automatically Capital Conservation Buffer Core Equity Bank is insolvent in Basel III (CET1<4.5%)

29 Will CoCo s Trigger? 29 Counter Cyclical Buffer % CoCo Trigger will recapitalize the bank automatically Capital Conservation Buffer Core Equity As soon as the bank eats into its buffers, it will no longer have the initiative : coupon payments, bonus payments are under regulatory scrutiny Banks could strengthen their capital base before a trigger occurs!

30 Quantitative Aspects of CoCos 30

31 CoCos Anatomy All CoCos are different 31 Maturity (> 5y) Coupon (7-10 %?) Trigger Event Accounting: e.g. CET1 <7% Regulatory Trigger Market Trigger (not implemented) Loss Absorbing Mechanism Conversion Conversion Price = Issue Price (Lloyds) CP = S 0 Conversion Price = fraction of Issue Price (BarCap) CP = α S 0 Conversion Price = Trigger Price CP = S* Floored Conversion Price (CS, BBVA, ) CP = max (Floor, S*) Write-Down Partially (Rabo (75%)) Full (Barclays, KBC, CS, ) Staggered (ZKB, ) Conversion/Write-Down Mechanism determines the Recovery Rate of the CoCo

32 CoCo Pricing 32 CoCos Pricing Methodologies n Credit Model (Rule of Thumb) n Equity Derivatives Model (Barrier Option Pricing) n Others (academic/hard to calibrate): - firm value valuation - jump models - stochastic vol models - - EXPECTED YIELD CALCULATION (8-10% Coupons) - (PROXY) HEDGING and RISK MANAGEMENT (death spiral effect) - ISSUE SIZE DETERMINATION (free-float vs short sales) - RELATIVE PRICING (investment strategies) 32

33 CoCo Pricing 33 Rule of Thumb Pricing for a CDS: Credit Spread = Expected Loss x Default Intensity cs = (1 R CDS ) x λ default Example 1: The Rabobank cds spread (senior) is 65bp. For an expected recovery rate of 40%, this corresponds to an estimate of λ default of 1.09% = 0.65%/(1-0.4). Rule of Thumb Pricing for a CoCo Spread: CoCo spread = (1 R CoCo ) x λ trigger Example : When will the Rabobank CoCo trigger: λ trigger =? On the trigger event, there is a haircut of 75%. The recovery is hence 25% (R CoCo = 25%). Suppose, the CoCo spread of the Rabobank CoCo is 304 bp. λ trigger = 3.04% / (1-0.25)= 4.05%. Note that conversion happens before default : λ trigger > λ default 450 RABOBANK CREDIT SPREADS 5.5 ONE YEAR DEFAULT/TRIGGER PROBABILITY RABOBANK bps SENIOR (40% Recovery) COCO (25% RECOVERY) c=304 Default Prob (%) Default Prob Trigger Probability λ Trigger =4.05% c=65 01 Jan May Oct Dec 2013 T λ Default =1.09% Jan May Oct Dec Feb 2014 T

34 CoCo Pricing : Equity Deriva?ves Approach Barclays CoCo Bond US06740L8C S /S(%) Non Callable CoCo [S1] Callable 10Yr NC5 (priced till call date) 8 01 Jan Apr Jul Dec 2013 T 34

35 Risk Management of CoCos 35

36 Past Performance doesn t tell us anything CoCo (Total Return) MSCI JPM Gvt Bond Index JP Morgan High Yield Index Dec 10 Jun 11 Dec 11 Jun 12 Dec 12 Jun 13 Feb 14

37 Past Performance doesn t tell us anything Period: :14 Feb Annualized Return (%) CoCo (Total Return) MSCI JPM Gvt Bond Index JP Morgan High Yield Index Realized Volatility (%) Volatility Tail Risk

38 Death Spiral Risk 38 The existence of the death-spiral puts a cap on the maximum amount of CoCos a bank can issue.

39 Death Spiral Risk Death Spiral Risk increases over time

40 Combing with convertible bonds? No! 40 n Convertible bonds have a positive convexity in normal market circumstances 2 P S 2 > 0 n In distressed market circumstances, the opposite is true

41 Extension Risk 41 n The increased issuance of AT1 CoCo bonds emphasizes the extension risk Issuance of Contingent Capital in Europe Additonal Tier 1 Tier 2 25 Issue Size ($ bn) Jan10 Jan11 Jan12 Jan13 Dec13 T

42 Extension Risk 42 n The increased issuance of AT1 CoCo bonds emphasizes the extension risk n Companies do not necessarily call back their bonds on the first call date n Example : Deutsche Bank did not call back a bond in Dec The market price of the bond dropped 10%

43 Extension Risk Extending a bond creates no longer a reputational issue 43 Source : barclays capital

44 Extension Risk 44 n CoCo bonds cannot be considered to expire on the first call date n The extension risk has been embedded into our two approaches : Credit Derivatives Method Equity Derivatives Method n New Concepts Expected Maturity Date Expected Extension Period Call Probability n Explanation is available for downloading :

45 Extension Risk : Example 45 Implied Trigger level for Barclays 20 Barclays CoCo Bond US06740L8C27 18 Implied Trigger Levels should not be different? S /S(%) S* Callable > S* Non-Callable The higher trigger level materializes the extension risk. The bond does not expire on the first call date 10 Non Callable CoCo [S1] Callable 10Yr NC5 (priced till call date) 8 01 Jan Apr Jul Dec 2013 T

46 Extension Risk : Example 46 Implied Trigger level for Barclays Barclays CoCo Bond US06740L8C27 Adjusting the model for a possible Extension risk creates a better fit between S* Callable and S* Non-Callable for the CoCo Bond S /S(%) Non Callable CoCo [S1] Callable 10Yr NC5 [S2] Callable 10Yr NC5 (with Extension Risk) [S3] 8 01 Jan Apr Jul Dec 2013 T

47 Questions? 47 n Jan De Spiegeleer [email protected] n Wim Schoutens (KU Leuven) [email protected]

48 References 48 [1] De Spiegeleer, J. and Schoutens W. (2011) Contingent Convertible Coco-Notes: Structuring & Pricing. EuromoneyBooks. [2] De Spiegeleer, J. and Schoutens, W. (2012) Pricing Contingent Convertibles: A Derivatives Approach. Journal of Derivatives, Vol. 20, No. 2: pp [3] De Spiegeleer, J., Schoutens, W. (2012). Steering a bank around a death spiral: Multiple Trigger CoCos. Wilmott Magazine, 2012 (59), [4] De Spiegeleer, J., Schoutens, W. (2013) Multiple Trigger CoCos: Contingent debt without death-spiral risk. Financial Markets, Institution and Instruments Journal 22 (2). [5] Corcuera, J. M., De Spiegeleer, J., Ferreiro-Castilla, A., Kyprianou, A.E, Madan, D., Schoutens, W. (2013), Pricing of Contingent Convertibles under Smile Conform Models. Journal of Credit Risk, Journal of Credit Risk 9(3), [6] Maes, S. and Schoutens, W. (2012) Contingent Capital: An In-Depth Discussion, Economic Notes, vol. 41, no. 1/22, pp [7] De Spiegeleer, J., Forys, M., Schoutens, W. (2012). Contingent Convertibles. In: Encyclopedia of Debt Finance Euromoney Books. [8] De Spiegeleer, J., Van Hulle, C., Schoutens, W. (2011). Cracking the coco pricing conundrum, July issue, pp: CreditFlux. [9] Madan, D.B. and Schoutens, W. (2011) Conic coconuts: the pricing of contingent capital notes using conic finance, Mathematics and Financial Economics, Volume 4, Issue 2, pp [10] Campolongo, F., De Spiegeleer, J., Di Girolamo, F. and Schoutens W. (2012) Contingent Conversion Convertible Bond: New avenue to raise bank capital. Working paper. [11] De Spiegeleer, J., Dhaene, J. and Schoutens, W. (2013). Swiss Re s $750m solvency trigger coco is much riskier than it seems. Credit Flux. Technical Analysis, April [12] Corcuera, J.M., De Spiegeleer, J., Fajardo, J., Jönsson, H., Schoutens W. and Valdivia, A. (2014) Close form pricing formulas for CoCa CoCos, Journal of Banking and Finance, to appear. [13] De Spiegeleer, J., Van Hulle, C., Schoutens, W. (2014). The Handbook of Hybrid Securities: Convertible Bonds, CoCo Bonds and Bail-In, The Wiley Finance Series.

49 APPENDIX 49

50 CoCos Anatomy (APPENDIX) European Contingent Convertible Issuance CoCo Bonds CoCo Bonds (Write Down) CoCo Bonds (Equity Conversion) USD (bn) Dec 09 Dec 10 Jan 12 Jan 13 Feb 14 T Inconsistency in how the conversion to equity takes place

51 CoCo Pricing (APPENDIX) 51 For Equity Conversion CoCos, the expected loss is determined by the value of the shares (S*) when conversion takes place : The CoCo investor pays Cp for each share with value S*: Recovery Rate (%) = R CoCo = S* / Cp ASSUME: Triggering happens when the stock prices hits a certain barrier. We replace the CET1 falling below X% event by Stocks hits the a low barrier H. Rule of Thumb Pricing : CoCo spread = (1 S* / Cp) x λ trigger Equity Model: Smile Adjusted Black-Scholes

52 CoCo Pricing : Equity Deriva?ves Approach (APPENDIX) 52 We break down a CoCo bond into different derivative instruments: A. Face Value + Coupons: BOND (long) B. Conversion into stock: DOWN-AND-IN-FORWARD (long) Write-down: BINARY DOWN-AND-IN-BARRIER (short) C. Cancellation of Coupons BINARY DOWN-AND-IN BARRIERS (short) CoCo Price = A (Bond Part) + B (Loss Absorption) + C (Coupon Loss) Pricing formula needs essentially two inputs: Volatility σ and implied trigger level S*