Contingent Convertible Research Articles

Convertible Debt Instruments in International Tax Law – Part 1

This two-part article contains an in-depth analysis of a variety of convertible debt instruments from the perspective of international tax law. Part 1 covers optional convertible instruments, mandatory and reverse convertibles, contingent convertibles, warrants and option loans and provides an overview of domestic law in a number of countries. Part 2, to be published in European Taxation 5 (2017), analyses the classification and treatment of the different types of convertible debt instruments from the perspective of EU corporate tax directives and tax treaties.

Contingent conversion convertible bond: New avenue to raise bank capital

This paper provides an in-depth analysis of the structuring and the pricing of an innovative financial market product. This instrument is called a contingent conversion convertible bond or “CoCoCo”. This hybrid bond is itself a combination of two other hybrid instruments: a contingent convertible (“CoCo”) and a convertible bond. This combination introduces more complexity in the structure but it also allows investors to profit from strong share price performances. This upside potential is added on top of the normal contingent convertible mechanics of CoCos, which expose the investors to mainly downside risk. First, we explain how the features of the contingent convertible bonds on one side and the features of the standard convertible bonds on the other side are combined. Thereafter, we propose a pricing approach which moves away from the standard Black[Formula: see text]Scholes setting. The CoCoCos are evaluated using the Heston process to which a Hull-White interest rate process has been added. We demonstrate the importance of using a stochastic interest rate when modeling this instrument. Finally we quantify the loss absorbing capacity of this instrument.

On the Propensity to Issue Contingent Convertible (CoCo) Bonds

In this paper we analyze the determinants of CoCo bond issuance. Moreover, the results suggest that banks who issue CoCo bonds in the BRICS and other emerging countries are typically large and have high leverage, aiming to meet the Basel III rules and replace debt with equity funding.

An examination of investors’ reaction to the announcement of CoCo bonds issuance: A global outlook

Major international financial institutions (FIs) are using contingent convertible (CoCo) bonds in the wake of the 2008 financial crisis to meet stricter national and international capital requirements. Beginning with UniCredit's €500m 9.375% CoCo in July 2010, more than 40 publicly held financial institutions headquartered in 16 countries have issued 68 CoCos. According to S&P's 2010 report, by the year 2020, CoCo bond volumes are expected to reach to $1 trillion. This paper examines investors’ reactions to the announcements of CoCo bonds issuances by FIs. Using event-study methodology and measuring cumulative abnormal returns (CARs) following the announcements, we find FIs generally experience negative abnormal returns during the post-announcement period; however, the investors’ reactions vary in a country-by-country analysis. These different reactions create opportunity for investors and issuers to launch global diversification and trading strategies.

Real options and contingent convertibles with regime switching

We consider a firm with no assets in place but an option to invest in a project. The investment is irreversible but delayable in a regime-switching economy. The firm issues equity, straight bonds (SBs) and contingent convertibles (CoCos). We provide the closed-form prices for the firm׳s securities and the pricing and timing of the option. Our numerical analyses discover that issuing CoCos instead of SBs induces much less agency cost of debt. The agency cost is higher in a boom economy than in recession but the difference is small. There is a unique CoCos׳ conversion ratio such that the agency cost arrives at the minimum value zero. The inefficiencies arising from asset substitution and debt overhang are much more significant in recession than in boom. Only if the conversion ratio is not too small, the two inefficiencies disappear during boom periods. While the effects of the conversion rate on optimal capital structure and firm value and those of supervision and jump intensity on optimal CoCos׳ coupon are ambiguous and weak, the stricter the supervision or the longer the economy remains in recession, the less the option value and the optimal SBs׳ coupon.

CoCo bonds and implied CET1 volatility

s at AFMathConf 2016 CoCo Bonds and Implied CET1 Volatility Ine Marquet KU Leuven Dep. of Mathematics, Celestijnenlaan 200B, 3001 Heverlee Belgium ine.marquet@wis.kuleuven.be Joint work with: J. De Spiegeleer, W. Schoutens In this talk we introduce the notion of implied Common Equity Tier 1 volatility and the concept of a risk-adjusted distance to trigger. Using a derivatives-based valuation approach, we are able to derive the implied CET1 volatility from the market price of a CoCo bond in a Black-Scholes setting. The numerical results show how different contingent convertibles issued by the same bank and sharing a similar contractual CET1 trigger, have almost identical implied CET1 volatility levels. The same results confirm the difference in market risk between Tier 2 and Additional Tier 1 CoCo bonds. The ability to obtain an implied level for the CET1 volatility offers other interesting results. We are able to determine the implied CET1 level corresponding to a coupon cancellation. It further allowed us for example to look at the severity of one of the stress tests imposed by the ECB on European banks in November 2014. In that perspective we were also able to derive implied PONV CET1 levels.

Forbearance Incentives: Undermining the Distinction between Going and Gone-Concern Capital

In absolute terms Contingent Convertibles (‘CoCos’) and the bail-in power achieve the same goal: the conversion of debt into equity or the write-down of debt. CoCos are issued as part of bank capital requirements under the Fourth Capital Requirements Directive and its Regulations. On the other hand, bail-in is a power under the Bank Recovery and Resolution Directive that can be applied by a regulator as part of resolution. CoCos are part of bank capital rather than being a resolution power and therefore we would expect that a conversion or write-down of a CoCo would take place prior to a bank being placed into resolution. This paper argues regulatory forbearance incentives mean that a CoCo trigger might occur concurrently with a bail-in rather than before a bail-in.

A Reexamination of Contingent Convertibles with Stock Price Triggers

Initial proposals for bank contingent convertibles (CoCos) envisioned that these bonds would convert to new equity when the bank's stock price declined to a pre-specified trigger, thereby automatically re-capitalizing the bank and enhancing financial stability. However, subsequent research argued that doing so causes the bank's stock price to have multiple equilibria or no equilibrium. This paper shows that when CoCos have a perpetual maturity, which characterizes the majority of actual CoCos, a unique stock price equilibrium exists except under unrealistic conditions. A unique equilibrium can occur when conversion terms are advantageous or disadvantageous to CoCo investors and when CoCos convert to new equity shares or are written down. Moreover, the existence of a unique equilibrium stock price is more likely when the bank's asset risk is higher, when there are direct costs of bankruptcy, and when CoCos are callable by the bank. We illustrate these results by developing models of CoCos with either perpetual or finite maturities that lead to closed-form solutions for stock and CoCo values.

Enhanced equity-credit modelling for contingent convertibles

Contingent convertible (CoCo) bonds are characterized by forced equity conversion under either an accounting or regulatory trigger. The accounting trigger occurs when the capital ratio of the issuing bank falls below some contractual threshold. Under the regulatory trigger, sometimes called the point-of-non-viability (PONV) trigger, the regulatory authority may enforce equity conversion when the financial health of the bank deteriorates to certain distressed level. In this paper, we propose an equity-credit modelling of the joint process of the stock price and the capital ratio that integrates both a structural approach for the accounting trigger and a reduced-form approach for the PONV trigger of equity conversion. We also construct effective Fortet algorithms and finite difference schemes for numerical pricing of CoCo bonds under various forms of equity conversion pay-off. The pricing properties of CoCo bonds are examined under different assumptions for the state-dependent intensity of the PONV trigger, the contractual specifications and market conditions.

Removing Moral Hazard and Agency Costs in Banks: Beyond CoCo Bonds

The convex payoffs for equityholders in a corporate structure results in agency costs and moral hazard problems. The implicit government guarantee for banks accentuates these. We believe that the Basel III related bail-in contingent convertible (CoCo) structures do only not solve these problems, but may even aggravate them. In this paper we suggest solutions. The first is to replace the currently issued writedown/off and equity-conversion CoCo structures with a market-price equity-conversion CoCo bonds. This mirrors the full dilution effect of an ordinary equity raise in a distressed situation to reduce incentives for high risk-taking by equityholders. The second is to establish a Contingent Equity Base that replaces the incumbent shareholders once the CoCo is triggered. This will finally remove the perverse risk-taking incentives. The valuation of the CEB is then suggested.

Testing a Model for Contingent Convertible (CoCo) with Market Data

In this paper a Contingent Convertible (CoCo) of Lloyds Banking Group will be examined. The Black-Scholes pricing of CoCo will be compared with market price as observed on the London Stock Exchange.

Contingent Convertibles and their Impacts on the Optimization of the Capital Structure of Brazilian Banks Under Basel III

Banks around the world maintain excess regulatory capital, whether to minimize capitalization costs or to mitigate risks of financial difficulties. However, it was only after the financial crisis of 2008 that the quality of capital gained greater importance among international regulators, through the Third Basel Accord (Basel III), which suggested a capital structure formed of the new equity and debt hybrid instruments, that is, Contingent Convertibles (CoCos), which have the main goal of recapitalizing banks automatically when they show signs of financial difficulties. Using the continuous-time structural model developed by Koziol and Lawrenz (2012), with December 2013 as a reference, this paper analyzes the capital structure of the 10 biggest Brazilian banks in terms of total assets, comparing their current structures - with only subordinated debts - with the structure proposed in Basel III, composed solely of contingent convertibles, with a view to verifying the influence of CoCos in banks' risks and evaluating the effectiveness of this Basel III recommendation. Through the evidence obtained using the model mentioned, this paper's main contribution is in demonstrating that the use of CoCos would optimize the capital structure of banks under the restrictions of Basel III, considering these are effective. If not, the automatic recapitalization of these instruments could be used for shareholders' own benefit, thus increasing the likelihood of banks experiencing financial difficulties, which could cause a new financial crisis, like that which occurred in 2008.

Real Options and Contingent Convertibles with Regime Switching

We consider a firm with no assets in place but an option to invest in a project. The investment is irreversible but delayable in a regime-switching economy. The firm issues equity, straight bonds (SBs) and contingent convertibles (CoCos). We provide the closed-form prices for the firm's securities and the pricing and timing of the option. Our numerical analyses discover that issuing CoCos instead of SBs induces much less agency cost of debt. The agency cost is higher in a boom economy than in recession though the difference is small. There is a unique CoCos' conversion ratio such that the agency cost arrives at the minimum value zero. The inefficiencies arising from asset substitution and debt overhang are much more significant in recession than in boom. Only if the conversion ratio is not too small, the two inefficiencies disappear during boom periods.

The Impact Of CoCo Bonds On Bank Value And Perceived Default Risk: Insights And Evidence From Their Pioneering Use In Europe

Contingent convertible (CoCo) bonds convert to equity during financial distress. They help transfer the responsibility for bearing the costs of poor performance from the taxpayers to the bank owners. Our results are thus relevant for investors, financial decision-makers, and regulators. We analyze the effects of the pioneering use of CoCos in Europe by Lloyds Banking Group in 2009. The bank’s motivation for the issue is explored, considering both its economic situation and the Basel III regulations. We document a reduction in the bank’s market value following the announcement of the intention to issue CoCos. Simultaneously, the credit default swap spread goes up. This study suggests that CoCos can have a negative effect on a bank’s creditworthiness and firm value.

The Global Impact of Coco Bonds on Bank Value and Default Risk: Insights and Evidence from Their Pioneering Use in Europe

Contingent convertible (CoCo) bonds convert to equity during financial distress. They help transfer the responsibility for bearing the costs of poor performance from the taxpayers to the bank owners. Our results are thus relevant for investors, financial decision-makers, and regulators. We analyze the effects of the pioneering use of CoCos in Europe by Lloyds Banking Group in 2009. The bank’s motivation for the issue is explored, considering both its economic situation and the Basel III regulations. We document a reduction in the bank’s market value following the announcement of the intention to issue CoCos. Simultaneously, the credit default swap spread goes up. This study suggests that CoCos can have a negative effect on a bank’s creditworthiness and firm value.

Enhanced Equity-Credit Modeling for Contingent Convertibles

Contingent convertible (CoCo) bonds are characterized by forced equity conversion under either accounting or regulatory trigger. Accounting trigger occurs when the capital ratio of the issuing bank falls below some contractual threshold. Under the regulatory trigger, sometimes called the point-of-non-viability (PONV) trigger, the regulatory authority may enforce equity conversion when the financial health of the bank deteriorates to certain distressed level. In this paper, we propose an equity-credit modeling of the joint process of the stock price and capital ratio that integrates both the structural approach of accounting trigger and reduced form approach of PONV trigger of equity conversion. We also construct effective Fortet algorithms and finite difference schemes for numerical pricing of CoCo bonds under various forms of equity conversion payoff. The pricing properties of the CoCo bonds under different assumptions of the state dependent intensity of PONV trigger, contractual specifications and market conditions are examined.

Numerical Pricing of Coco Bonds with Parisian Trigger Feature Using the Fortet Method

Unlike conventional convertible bonds, contingent convertible (CoCo) bonds are converted into equity shares of the issuing bank subject to certain trigger mechanisms (accounting and/or regulatory trigger) when the issuing bank is under financial non-viable state. We consider pricing of these CoCos using the contingent claims approach, where the state variables are the stock price and Tier 1 capital ratio. We use the Parisian feature to model the regulatory trigger where equity conversion is triggered when the capital ratio stays under the non-viable state cumulatively for a certain period of time. The accounting trigger is modeled using the one-touch barrier feature associated with the capital ratio. The Parisian trigger feature adds one extra path dependent state variable in the pricing model of a CoCo bond. We design effective numerical algorithms for pricing the Coco bonds using the extended Fortet method that avoid the issuance of adding one state variable for the Parisian feature of regulatory trigger. Pricing properties of the CoCo bonds under both regulatory trigger and accounting trigger are explored.

Regulatory and Economic Incentives for Issuing Contingent Convertibles

A contingent convertible (CoCo) is a specific type of a convertible bond where conversion (or write-down of a face value) is not an option at the discretion of a bondholder but is forced when regulatory capital fails to meet a predetermined level. That unique feature creates the loss absorbing ability of a CoCo, - a regulatory goal that seems not to be effectively implemented under a pre-crisis legal framework on tier-based capital structure. Use of CoCos for bank recovery and resolution purposes is a vital element of a Bank Recovery and Resolution Directive (BRRD) legal framework. In new CRD IV/CRR regime each AT1 debt instrument must be either a CoCo or a bail-in bond.The open question is how to quantify the impact of the replacement of classical bonds by CoCos on the risk exposure of the issuer. We propose certain scheme how to calculate the decrease of risk measures like Value-at-Risk or Expected Shortfall implied by such change of the issuer’s debt policy.

The Effects of Contingent Convertible (CoCo) Bonds on Insurers' Capital Requirements Under Solvency II

The Liikanen Group proposes contingent convertible (CoCo) bonds as a potential mechanism to enhance financial stability in the banking industry. Especially life insurance companies could serve as CoCo bond holders as they are already the largest purchasers of bank bonds in Europe. We develop a stylized model with a direct financial connection between banking and insurance and study the effects of various types of bonds such as non-convertible bonds, write-down bonds and CoCos on banks' and insurers' risk situations. In addition, we compare insurers' capital requirements under the proposed Solvency II standard model as well as under an internal model that ex-ante anticipates additional risks due to possible conversion of the CoCo bond into bank shares. In order to check the robustness of our findings, we consider different CoCo designs (write-down factor, trigger value, holding time of bank shares) and compare the resulting capital requirements with those for holding non-convertible bonds. We identify situations in which insurers benefit from buying CoCo bonds due to lower capital requirements and higher coupon rates. Furthermore, our results highlight how the Solvency II standard model can mislead insurers in their CoCo investment decision due to economically irrational incentives.

The Effects of Contingent Convertible (CoCo) Bonds on Insurers’ Capital Requirements Under Solvency II

The Liikanen Group proposes contingent convertible (CoCo) bonds as a potential mechanism to enhance financial stability in the banking industry. Especially life insurance companies could serve as CoCo bond holders, as they are already the largest purchasers of bank bonds in Europe. We develop a stylised model with a direct financial connection between banking and insurance and study the effects of various types of bonds such as non-convertible bonds, write-down bonds and CoCos on banks’ and insurers’ risk situations. In addition, we compare insurers’ capital requirements under the proposed Solvency II standard model as well as under an internal model that ex ante anticipates additional risks due to possible conversion of the CoCo bond into bank shares. In order to check the robustness of our findings, we consider different CoCo designs (write-down factor, trigger value, holding time of bank shares) and compare the resulting capital requirements with those for holding non-convertible bonds. We identify situations in which insurers benefit from buying CoCo bonds due to lower capital requirements and higher coupon rates. Furthermore, our results highlight how the Solvency II standard model can mislead insurers in their CoCo investment decision due to economically irrational incentives.