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Set out how contingent convertible bonds (CoCos) work and why banks have an incentive to issue them.

FRM® Part II · Operational Risk and Resilience · Solvency, Liquidity, and Other Regulation After the Global Financial Crisis · FRM2.ORR.22.g

The idea

A contingent convertible bond, or CoCo, is a bond that either converts into common equity or has its principal written down when a trigger is hit. The trigger is usually a CET1 ratio falling below a stated level, or a supervisor's judgment that the bank is no longer viable. Before the trigger it pays a coupon higher than ordinary debt. After it the bank has new equity, or a smaller liability, without having to raise capital in a stressed market. Banks like them for three reasons. Well-designed CoCos count as Additional Tier 1 or Tier 2 capital. The coupon is usually tax deductible as interest while dividends are not. Shareholders are diluted only if the bank gets into trouble. Conversion at a low market price can mean heavy dilution and invites short selling, so a fixed conversion price is the alternative. The distinction to keep is conversion versus write-down.

Formulas

Share of the bank owned by former CoCo holders

Share = (P ÷ Pc) ÷ (N + P ÷ Pc)

P
the CoCo principal
Pc
the conversion price per share
N
the shares in issue before conversion

With a fixed conversion price the market price at the trigger does not change the share count, only the value of the new shares.

After-tax cost of a CoCo coupon

Cost = c × (1 − t)

c
the coupon rate
t
the tax rate

Holds when the coupon is tax deductible as interest. Dividends on equity get no such deduction.

A practice question

From the question bank, with the reason each wrong option is wrong.

Why do banks have an incentive to issue CoCos?

  1. They carry lower coupons than senior debt because conversion gives the investors an upsideWhy not: CoCos carry higher coupons than senior debt because of the loss-absorption risk.
  2. They improve the liquidity coverage ratio by adding to the stock of high-quality liquid assetsWhy not: CoCos are a source of capital, not liquid assets, and do not raise HQLA.
  3. They avoid any dilution of existing shareholders because conversion takes place at par valueWhy not: Conversion can dilute shareholders if the trigger is hit; the benefit is that dilution happens only in distress.
  4. They count as regulatory capital, give a deductible coupon, and recapitalise the bank in a crisis - correct

CoCos are cheaper to the bank than new equity in good states, count towards AT1 or Tier 2 capital, offer a deductible coupon and give automatic loss absorption in distress.

A harder one

A CoCo with principal of USD 240 million converts into shares at a fixed conversion price of USD 12 per share when its trigger is hit. The bank has 130 million shares in issue before conversion, and the share price at the trigger is USD 8. The percentage of the post-conversion shares held by the former CoCo holders is closest to:

  1. 13.3% - correct
  2. 15.4%Why not: Divides the new shares by the old shares instead of the post-conversion total.
  3. 18.8%Why not: Converts at the market price of USD 8 instead of the fixed conversion price of USD 12.
  4. 23.1%Why not: Uses the market price instead of the fixed price and also omits the new shares from the denominator.

New shares = 240/12 = 20 million. Ownership = 20/(130+20) = 13.3%.

The hardest tier

A CoCo of USD 400 million converts into shares at a fixed conversion price of USD 20 per share set at issue. When the trigger is hit the share price is USD 8 and 100 million shares are outstanding. Which pair of outcomes is correct for the former CoCo holders?

  1. They hold 33.3% of the shares, worth USD 400 millionWhy not: Assumes conversion at the market price of USD 8, which restores their full principal; the conversion price here is fixed.
  2. They hold 16.7% of the shares, worth USD 400 millionWhy not: Gets the share count right but values the shares at par, ignoring the fall in the share price to USD 8.
  3. They hold 16.7% of the shares, worth USD 160 million - correct
  4. They hold 20.0% of the shares, worth USD 160 millionWhy not: Divides new shares by old shares only, omitting the new shares from the denominator.

New shares = 400/20 = 20 million. Ownership = 20/120 = 16.7%. Market value = 20 x 8 = 160 million, so holders take a loss of 240 million versus par.

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