Sales of contingent convertible (Coco) bonds, a high-risk debt/equity hybrid offering an attractive option for banks to boost Tier 1 capital, have tripled in the conventional market this year as issuers leverage the low interest rate environment to chase higher-yielding debt. LAUREN MCAUGHTRY explores whether these complex new instruments could present a new alternative for the Islamic debt markets, as banks seek new avenues to boost Basel III capital.
Banks have jumped aboard the bandwagon with enthusiasm: and from around US$20 billion in 2012 the market has soared to US$64 billion so far this year, with Credit Suisse anticipating a further US$20 billion by the end of December. Major players such as Barclays, UBS, Credit Agricole, Nomura, Swiss Re and Societe Generale have all issued Cocos, which are now one of the fastest-growing components of the European market. A recent issuance from HSBC in September saw a reported US$8 billion-worth of orders, while just last week Deutsche Bank priced US$1.5 billion at a reported 7.5% yield with an orderbook of over US$3.5 billion — and a clutch of banks in the Middle East and Asia are also lining up to join the fray. So what are these new tools — and are they really the dream solution the banks are painting them as?
A cautious compromise
Coco bonds are perpetual, fixed-coupon debt securities that can either be converted into equity or be permanently (or temporarily) written down in the event of a certain trigger — such as if the bank’s Tier 1 capital falls below a certain margin — thus increasing the bank’s equity and recapitalizing in the event of a crisis. For example, Deutsche Bank’s Tier 1 capital currently stands at 14.5%, while the trigger for its recent Coco issuance is set at 5.125%.
The key feature here is that, unlike existing hybrid debt instruments, the conversion is compulsory with Coco investors forcibly changed from debt-holders to junior shareholders — making the bonds extremely high risk and thus, inevitably, giving them a high equivalent yield to make them worth holding. This compromise between debt and equity represents an uneasy truce between banks and regulators, allowing banks to meet the more restrictive requirements of Basel III regulation while still taking advantage of the more favorable tax treatment and higher investor demand for debt over equity.
A conventional curve
The tool has been widely accepted in Europe, with the trend spurred by the Capital Requirements Directive IV from the European Central Bank recognizing Coco bonds as equity capital. The majority of issuance has so far come from the UK and Switzerland, although Canada is also a strong player; and former US treasury secretary Timothy Geithner has lent his support, claiming that the bonds have the potential to function as shock absorbers during market upheavals, while the US Financial Stability Oversight Council in 2013 enacted a study on the characteristics and triggering mechanisms of contingent capital.
Yet so far, there has been extremely limited take up of this option in the Islamic world, with almost no attention yet paid to the tool by Shariah compliant banks. One reason could be the higher levels of equity normally held compared to conventional banks, which has limited their requirement to raise further capital. Yet the spate of hybrid Tier 1 Sukuk issuance from Gulf banks over the past couple of years suggests that there is still an unmet requirement for capital. On paper, the risk-sharing, debt/equity elements of Coco bonds look ideal for accessing Islamic finance — so what other reasons are holding banks back?
A risky business
One of the key issues could be the growing global concern over the high-risk aspects of the instrument. The occurrence of a trigger event can of course result in a partial or total loss of invested capital if the paper is written down — but there are multiple other risk factors involved. For example, investors may not be aware that issuers of Coco bonds have the option to suspend coupon payments, either temporarily or permanently, resulting in a loss of the expected return. The bank also has the right to use the withheld funds to repay its own obligations, meaning that suspended coupon payments are not subsequently repaid.
There is no guarantee that the invested sum will be repaid on a certain date either, as according to the Federal Financial Supervisory Authority of Germany in its recent guidance note: “It is only possible to terminate, redeem or repurchase such instruments if the supervisory authority issues an authorization to do so. Generally speaking, this is not even possible until five years after the issue of the Coco bonds. Moreover, the competent supervisory authority may only grant such authorization if the bank — simply put — continues to satisfy the regulatory requirements for sufficient capital adequacy.”
These concerns have led to a number of regulatory reviews and warnings over the instrument’s usage in a retail context. The Joint Committee of the three European Supervisory Authorities (EBA, ESMA and EIOPA) in July 2014 issued a warning to financial institutions reminding them of their legal requirements regarding the distribution of financial instruments to retail clients; while the European Securities and Markets Authority (ESMA) also issued a statement to institutional investors highlighting the potential risks in Coco investment. In August, the UK Financial Conduct Authority went one step further by issuing a series of restrictions limiting the retail distribution of Coco bonds, noting that: “We regard Cocos as posing particular risks of inappropriate distribution to ordinary retail customers (i.e., retail clients who are neither sophisticated nor high net worth or who do not meet any of the other permitted criteria). The restrictions will limit the ability of firms to distribute Cocos to retail customers.”
So far there has been no communication or guidance from Islamic regulatory bodies regarding the use of Coco Sukuk — or even an acknowledgement of the possibility. But are these issuances an option in the Shariah compliant space?
In fact, there is already a quiet groundswell of interest, and we could be seeing some Islamic Coco issuances in the near future. Mohammed Khnifer, a certified Shariah advisor and auditor, explained to IFN some of the challenges involved in a recent project structuring Coco Sukuk.
“We came out with three structures with different Islamic contracts. One noticeable remark that we had to address was the risk exposure that the Sukukholder needs to have (versus a plain vanilla Sukuk structure where the repurchase undertaking is [already] there).” This represents an issue regarding the dilution of the original shareholders’ equity value upon conversion, as Coco Sukukholders get a larger fraction of the total number of shares outstanding.
Questions also exist around the underlying assets that could be used to back a bank-issued Coco Sukuk, and the source of the cash flows. Another challenge is the amount of acceptable Gharar, as in typical Coco structures there is not only a price risk involved with equity conversion, but as the market price for the shares is only known at maturity, Gharar becomes a significant issue. “In our case, therefore, in all three proposed Coco structures, the trigger event will be pre-specified. Hence, the amount of Gharar that affects the validity of the contract is not that high. It will be up to the Shariah scholars to decide whether there should be a pre-specified call option, by the bank, linked to the trigger event,” explained Mohammed.
A growing need
According to a 2012 report from Arqaam Capital, up to 20% of banks in the Middle East and North Africa will need fresh capital to safely meet requirements under the global Basel III banking rules. In addition to the 9.5% of Tier 1 capital listed by Basel as necessary for systemically important banks, MENA banks also require a 2.5% premium due to their higher risk factors, suggesting that the need for capital raising in the region could increase.
“Islamic banks should start to consider how they will be able to build up their Capital Conservation Buffer (a form of common equity) or they will not be able to pay dividends or bonuses for those who are unable to comply,” warned Mohammed. “The Islamic finance industry has almost abandoned the development of hybrid securities, choosing the plain vanilla instruments. With the introduction of Basel III, Islamic banks will be in a disadvantaged position, compared with their conventional peers.” This raises the possibility that banks could soon be scratching around for new methods of capital increase that could grow the appeal of the Coco option.
A limited market?
Despite the established need and potential opportunity however, the development of a realistic market for Coco Sukuk still looks to be some way off. A regulatory mandate for Coco issuance under Basel III has not yet been introduced; and while conventional banks are issuing under their own regulatory guidance, the absence of legislation in most Islamic countries will inevitably limit participation.
Should an inaugural Coco Sukuk be issued in the coming months, this could act both as a benchmark for further issuance and a stimulus for an institution such as the IFSB to issue guidelines on Islamic contingent convertible capital and suggest parameters for their relationship to banks’ Tier 1 and Tier 2 capital.
Yet despite the obvious attraction for banks and regulators for this new instrument, its allure for investors is less easy to understand. Although the yields are high, these may not make up for the risks involved, with investors potentially left holding worthless equity or, at worst, losing their investment altogether. And with such limited downside protection, originators may steer shy of paying such high yields. In a crisis situation, the instruments might hold an attraction if the alternative is bankruptcy or, for existing investors, deferral of interest or default. Outside of it however, the paper is both expensive for banks to issue and risky for investors to hold — not to mention a distribution limited to the institutional market.
The yield appeal may be compelling, but in this case it looks as if the risk could perhaps outweigh the return.
Coco conditions create cause for concern
A recent study conducted by the Technical University of Munich and the University of Bonn suggests that if Coco bonds are poorly structured they have the potential to negatively impact the stability of the banking system during a crisis, rather than the touted advantage of averting bankruptcy for affected banks through equity conversion and capital raising.
Professors Christoph Kaserer and Tobias Berg developed a model to analyze conditionally convertible bonds and investigate the structure and performance of existing Coco bonds in the market. The results suggested that a write-down condition is present in around half of outstanding Coco bonds, while in the majority of the rest, the conversion ratio from debt to equity was unfavorable for the bondholder and the total value of shares received would be lower than the original value of their bondholding — an effect the report authors label as ‘convert to steal’.
The model suggests that the use of Coco bonds could also create incentives for banks that could escalate a crisis, as they could be tempted to worsen their own situation deliberately in order to reach the trigger point faster and thus release the capital tied up in the Coco paper. “As a consequence, the existence of Coco bonds could have an effect that worsens a crisis, because owners benefit from the fact that things are getting even worse for a bank – at least short-term,” noted Berg.
In comparison, if the bondholders were to receive an equal number of shares at market value, this would lead to resentment from the existing shareholders, who would be likely to attempt to prevent this from happening by ensuring that the trigger point was not reached. “This construction – which we call ‘convert to surrender’ — would consequently have a stabilizing effect on the banking system,” explained Berg.
“Coco bonds are a reasonable option for banks to improve their equity backing,” concluded Kaserer. “But they only help to stabilize the banking system if they are constructed correctly.”
Tobias Berg, Christoph Kaserer: ‘Does Contingent Capital Induce Excessive Risk-Taking?’ Journal of Financial Intermediation, 2014