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Contingent Convertible Bonds

October 2013

ANSHUMAN PRASAD

Director, Risk and Analytics

CRISIL Global Research & Analytics

SPEAKER

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Executive Summary

Rising Importance of CoCo Bonds

– CoCo bonds or contingent capital has taken off in a big way and can be considered a

new asset class

– CoCo issuances have exceeded $20 billion in 2012 and 2013

– Past issuances have met with success, with oversubscription being the norm

CoCo bonds’ regulatory environment, features and valuation techniques are

in a flux and are still evolving

– CRD IV directives, coming into force from January 1, 2014, envisage the use of

contingent capital as Additional Tier 1 capital

– Industry is slowly moving to a certain standard: write-down feature, point of non-viability

(PONV) trigger, etc.

– Valuation methodologies are evolving as academicians try to keep pace with the market!

– Innovation in structures is still continuing (e.g., recent Swiss Re CatCoCo)

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Rising interest in CoCo Bonds

CoCo Bonds: An Overview (1/2)

What are Contingent Convertible Bonds?

– CoCo bonds are hybrid capital securities that absorb losses in accordance with their

contractual terms when the capital of the issuing bank falls below a certain level

– The first CoCo bonds were offered by Lloyds in November 2009, which exchanged

CoCos for its outstanding subordinated bonds

– CoCo issuance volumes are rising and are expected to reach $1 trillion (S&P estimates)

3

Source : Contingentconvertibles.com, CRISIL GR&A Analysis, as of Sep,16 2013

3.2 - others

12.8 - others

2.2 - Nomura

3.5 – Banco do Brasil

9.7 - others

1.3 - others

2.3 -Allied Irish bk.

3.7 – Soc Activos

4.0 – Banco do Brasil

16.3 - Lloyds Banking

group

1.7 - Rabobank

4.0 - Rabobank

4.0 - UBS

7.0 - Credit Suisse

0

5

10

15

20

25

2009 2010 2011 2012 2013

16.3

3.0

11.7

20.7

24.1

US

D B

illio

ns

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CoCo Bonds: An Overview (2/2)

Why were Coco Bonds introduced?

– As a bail-in mechanism to infuse additional capital under adverse market conditions

– Can be used as regulatory capital under Additional Tier 1 and Tier 2 of Basel guidelines

– Transfer of risk from taxpayers to the private sector in times of distress

Factors Favoring CoCo Bonds

– Regulatory support, especially in Europe as seen in CRD IV and FINMA (Switzerland)

guidance

– Search for high-grade yield by investors

4

Banks and insurance companies that have issued CoCo bonds include:

Lloyds Bank Rabobank Credit Suisse UBS Barclays

Bank of Ireland Swiss Re KBC Bank BBVA Société Générale

Credit Agricole Nomura Macquarie Bank Bank of Brazil VTB Bank

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CoCo Bond Structures

Types of CoCo Bonds

– Contingent convertible bonds feature conversion into equity of the issuer in case the

trigger conditions are met at a pre-determined conversion price/ratio

– Contingent bonds feature a write-down of the principal amount of the bonds upon the

occurrence of a specific trigger event

– Principal write-down features are increasingly favored by regulators

5

Source: Bank of International Settlements 1

Main design features of

CoCos

Trigger Loss Absorption

Mechanism

Mechanical Discretionary Conversion to

Equity

Principal

Writedown

Book-value Market-

value

and

and/or or

or

Features of CoCo Bonds

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Comparison of Features of CoCo Bonds Issued

6

Classification Description Example

By type of trigger event

Book Value/Accounting based Core Tier 1 ratio falling below defined % Barclays (2013)

Market Value/Market based Share price/CDS spread linked None

Discretionary Trigger Triggered by national regulator BBVA (2013), Barclays (2013)

Dual Trigger Accounting + Discretionary Trigger Credit Suisse (2010)

By level of the trigger

High-trigger CoCo Additional Tier 1 capital Société Générale (2013)

Low-trigger CoCo Tier 2 capital Nomura (2011), Bank of Ireland (2013)

By Loss absorption mechanism

Conversion into equity Fixed number or value of shares Lloyds bank (2009)

Principal write-down Write-off of principal value Rabobank (2010)

Source: Bank of International Settlements 1, CRISIL GR&A Analysis

Recent Issuances

– Predominantly additional Tier 1 issuances with a discretionary trigger-based principal

write-down feature

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Regulatory Treatment of CoCo Bonds

Tax Treatment of CoCo Bonds can be complex

– Depending on the features, CoCo bonds can be treated as debt or equity for tax

purposes

– If treated as equity, coupon payments may not be eligible for tax benefits, reducing their

attractiveness

– Regional differences in tax treatment exist – eg., certain CoCos issued in response to

guidelines may be treated as equity, specifically in the US (Sundaresan & Wang, NY

Fed, Nov 2011)

Options for issuing CoCo Bonds

– Regulation S (preferred by a majority of European issuers)

– For US issuance, the predominant options include 3(a)(2) issuances /SEC registration

Treatment by National Prudential Regulation Authorities

– Majority of issuers are currently European, but there are differences between Swiss

guidelines and CRD IV

– As CoCos become an accepted instrument in a bank’s capital structure, the US may

also follow suit with further guidance (Report To Congress On Study Of Contingent

Capital, 2012)

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European Treatment of CoCo Bonds

CRD IV was approved on April 16, 2013 and will come into force on January

1, 2014

Key features of CRD IV/EBA guidelines

– CoCos or Buffer Convertible Capital Securities (BCCS) will be recognized as Additional

Tier 1 capital

– BCCS need to be direct, unsecured, undated and subordinated

– Trigger levels are set at 5.125% and 7%

– Loss absorption features are either in terms of principal write-down or equity conversion

– National regulator determined point of non-viability (PONV)

– Coupon payments can be canceled at the discretion of issuer/national regulator

Open Issues still to be addressed include:

– Further clarity on redemption incentives (e.g., call options or ability of investor to convert

into common equity)

– Write-up provisions

– Guidelines on the timing of the trigger event and write-down/conversion

BBVA Additional Tier 1 bonds, issued on April 29, 2013, were the first to

comply with CRD IV; they received a positive response

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Swiss Contingent Capital Regulations

9

Basel II Basel III Switzerland

Basel II = 8%

Basel III = 10.5%

Swiss = 19%

2% Common Equity Tier 1 (CET1)

2% Other Qualifying Tier 1 (OQT1)

4% Tier 2

4.5% Common Equity

Tier 1

2.5% Capital Conservation

Buffer

1.5% Other Qualifying Tier 1 (OQT1)

2% Tier 2

0% up to 2.5% Countercyclical

Buffer

4.5% Common Equity

Tier 1

+ 5.5%

Common Equity Tier 1

3% High Level

Trigger CoCos

6% Low Level

Trigger CoCos tbd

SIFI capital surcharge

+

>13%

Swiss regulations allow low-and high-level triggers at 5% and 7%

Source: IMF Staff discussion note 2

Comparison of Swiss Proposals and Basel III Proposal

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Performance of New issues

Key Considerations for Bond Issuers

Specific considerations for the CoCo Bond Issuers include:

– Regulatory capital treatment: differences in treatment by national regulators

– Tax considerations

– Ratings considerations: S&P guidelines

– Capital Structure considerations: Additional Tier 1 or Tier 2 dilution effects

– Setting the triggers: High/low trigger

10

88

92

96

100

104

108

112

3-Apr-13 21-Apr-13 9-May-13 27-May-13 14-Jun-13 2-Jul-13 20-Jul-13 7-Aug-13 25-Aug-13 12-Sep-13 30-Sep-13

CREDIT SUISSE UBS AG BANCO BILBAO VIZCAYA ARG BARCLAYS BANK PLC

Source: Bloomberg, CRISIL GR&A Analysis

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Key Considerations for Bond Investors

Yield: Risk v/s Yield for various categories of investors

Rating: Certain categories would not be able to invest in unrated CoCo bonds

Tax Treatment: Debt or equity treatment

Equity Conversion or Write-Down: Certain fixed income investors are not able to invest in

convertibles to equity; on the other hand, full principal write-down increases risks

11

One-year performance of selected CoCos

95

100

105

110

115

Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13

MQGAU 10 1/4 06/20/57 LLOYDS 7 5/8 10/14/20 SRENVX 7 1/4 09/29/49

CS 7 1/8 03/22/22 VTB 9 1/2 12/29/49 RABOBK 6 7/8 03/19/20

Avg. Return: 5.8%

Avg. Sharpe Ratio: 1.4

Source: Bloomberg, CRISIL GR&A Analysis

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Lower adoption by hedge funds, banks and insurance firms

Higher acceptance by private banks and retail investors followed by asset management firms

Typical Investors in CoCo Bonds

12

Attractive yields are drawing investors; yields are, on average, 3-5 percentage points higher than other

non-CoCo subordinated debt and senior unsecured debt of the same issuer

Europe and Asia-based private investors and private banks are the key target

However, the response to recent issuances was not as favorable as in the past (e.g., SocGen)

Reg S issuances by European banks have received a favorable response

Demand from asset management firms is also picking up

Till recently, CoCo bonds were unrated

Ratings are five notches below senior unsecured debt of same issuer

Banks holding CoCo bonds directly increase systemic risks

Correlated with business cycles — no significant diversification benefits to the portfolio

Regulatory treatment not yet clear in many jurisdictions

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The Payoff Structure of a CoCo Bond is quite different from that of a Convertible Bond

Valuation of CoCo Bonds (1/2)

13

0

20

40

60

80

100

P

S

Convertible CoCo Bond Floor ParityS

Source : Spiegeleer and Wim Schoutens 4

Design of a Valuation Model for a CoCo Bond is driven by:

Modeling the underlying trigger

Capital Ratio, Market Price, CDS Spreads, Discretionary, Multivariate

Value of CoCo at conversion

Fixed Value Conversion, Fixed Number Conversion, Principal Write-off

Additional Features

Callability

Unlimited downside,

limited upside

Limited downside,

unlimited upside

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Determinants of a Contingent Convertible's Value

Valuation of CoCo Bonds (2/2)

14

Value of Bond Part Value of Equity Part Probability of Conversion

Trigger Underlying Trigger Level

Maturity

Coupon Rate

Conversion

Ratio

Nominal

Amount

Conversion

Fraction

Risk

-free

Rate

Stock

Price

at

Conv.

Source : Markus P.H. Buergi 3

Pricing Approaches

In the industry, a variety of tree-based simulation approaches are used for pricing these instruments,

mainly using CDS spreads and/or ratings for calibration

Modeling approaches proposed in academic literature have included:

Equity and Credit Derivatives Modeling approaches (under Black Scholes); Jan De Spiegeleer, Wim

Schoutens (2011). A later paper extends these approaches under Smile conform models

Structural modeling approach; George Pennachhi (2011), Markus P.H. Buergi (2012)

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Modeling Limitations and Challenges

Valuing CoCo Bonds is challenging because of many reasons, including:

– Lack of clarity on point of non-viability (PONV) regulatory triggers

• Trigger is discretionary by design

– Challenges in linking market observable parameters to pricing

• E.g., Share prices and CDS spreads

– Market size, liquidity and number of issuers

• Lack of data points

– Frequency of data reported

• Infrequent updating of data (e.g., accounting ratios and credit ratings)

– Wide variation in features

• Quite a lot of combinations are possible in product features, making every CoCo issuance unique

in some respects

Newer models are being developed in the industry and in academia to tackle

these challenges

– Given the rising importance of CoCos and their effect on the banking system, it would be

good to have a variety of models available for proper model benchmarking

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Assessing Risks

16

Market Breadth and Depth

Many major investor classes do not yet invest in CoCos because of

the taxation issues involved, security classification and lower ratings Adverse News Causing Trigger

The occurrence of the trigger event itself has a negative signaling

effect, causing unwanted pain to the issuer Rollover Risks

CoCos are less effective near maturity

Manipulation Risk

Investors could make a manipulative attack to cause a trigger event to

their benefit Effectiveness in Systemic Crisis

Diversification of systemic risk might not happen if CoCo bond holders

themselves are systemically important Pricing Risks

Pricing is model dependent and is based on assumptions

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References

1. Stefan Avdjiev, Anastasia Kartasheva, Bilyana Bogdanova 1 (2013), CoCos: a primer, BIS Quarterly Review, September 2013

2. Ceyla Pazarbasioglu, Jianping Zhou, Vanessa Le Leslé, Michael Moore 2 (2011), Contingent Capital: Economic Rationale and Design Features,

IMF Staff Discussion Note, January 25, 2011

3. Markus P.H. Buergi 3 (2012), A tough nut to crack: On the pricing of capital ratio triggered contingent convertibles, Department of Banking and

Finance, University of Zurich, March 12, 2012

4. Jan De Spiegeleer, Wim Schoutens 4 (2011), Pricing Contingent Convertibles: A Derivatives Approach, Katholieke Universiteit Leuven, March 18,

2011 Financial

5. Stability Oversight Council (2012), Report To Congress On Study Of A Contingent Capital Requirement For Certain Nonbank Financial Companies

And Bank Holding Companies.

6. Sascha Wilkens, Nastja Bethke (2013), Contingent Convertible (“CoCo”) Bonds: A First Empirical Assessment of Selected Pricing Models, 9th

August 2013.

7. George Pennacchi (2010), A Structural Model of Contingent Bank Capital – Working paper , Federal Reserve Bank of Cleaveland

8. Wilson Ervin (2011), A new pull for CoCos, risk.net/risk-magazine, August 2011

9. Francesca Di Girolamo, Francesca Campolongo, Jan De Spiegeleer, Wim Schoutens (2012), Contingent Conversion Convertible Bond: New

avenue to raise bank capital

10. HM Treasury (2012), Banking reform: delivering stability and supporting a sustainable economy

11. Suresh Sundaresan, Zhenyu Wang (2011), On the Design of Contingent Capital with Market Trigger, Federal Reserve Bank of New York Staff

Reports, no. 448, November 2011

12. Basel Committee on Banking Supervision (2011), Basel III: A global regulatory framework for more resilient banks and banking systems, Bank for

International Settlements, June 2011

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www.crisil.com/gra

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Annexure 1: Credit Derivatives Approach

19

Modeling Methodology

Credit Spread,

LambdaTrigger

Here, Recovery Rate = Stock Price Initial/Conversion Price

LambdaTrigger is the default intensity and is related to the Survival Probability

Survival Probability = exp ( - LambdaTrigger

The accounting or regulatory trigger is assumed to be related to a trigger on the share price

Finally, in a Black-Scholes environment, one can get the survival probability, which is dependent on the dividend yield,

interest rate, volatility, maturity and current share price

Model Intuition

The main feature of a CoCo bond is conversion in case of financial distress of the company. The credit spread is therefore

closely related to computing the survival probability and recovery rate

Limitations of the Model

Does not incorporate the non-negligible stream of future coupon payments that the holder of the CoCo bond forfeits at

conversion. Quite important as it could result in CScoco = 0, in certain cases

The method does not result in a unique implied trigger level. This results in different trigger levels for similar CoCo bonds

issued by the same issuer with varying coupons

Source: Spiegeleer and Wim Schoutens (2011) 4

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Limitations of the Model

Annexure 2: Equity Derivatives Model

20

The payoff structure of a CoCo bond is replicated by a combination of different instruments

CoCo Bond = Zero Coupon Corporate Bond + Knock in Forward(s) -

Coupon-bearing bond reflects the coupon payments before conversion takes place

The knock-in forward represents the trigger event, at which the CoCo bond holder exchanges the bond against shares at a

pre-determined strike price

The binary down-and-in options reflect the cancellation of the coupon payments after the conversion has taken place

Modeling Methodology

Model Inputs

Stock price, Dividend yield and Implied volatility of embedded options — all market observable

Closed form solution for CoCo bond price and sensitivities

Straightforward parameterization similar to equity options

It does not model capital ratio trigger — most early issues of CoCo bonds are based on capital ratio trigger

Source: Spiegeleer and Wim Schoutens (2011) 4

Model Intuition

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Model Intuition

Modeling Methodology

Limitations of the Model

Annexure 3: Structural Model

21

The institution’s balance sheet structure is the main price driver

These models are based on modeling the institution’s assets and liabilities (with the difference giving the institution’s capital)

Describe processes for the institution’s assets and liabilities and impose contingent capital conversion into equity when the critical

capital-to-asset threshold has been reached

Model Inputs

Market Observable: Risk-free rate and asset value (proxied using market capitalization)

Balance Sheet linked: Bank deposits and leverage ratio

Non-Observable: Mean reversion speed for deposits, asset volatility, jump intensity, mean and volatility governing jump size

The CoCo bond is priced by Monte Carlo simulation of both the asset and the liabilities processes

The coupons paid along a given asset path are discounted, as well as the CoCo bond notional at maturity if trigger or

default has not taken place, or the conversion amount if the bond has converted

The CoCo bond price equals the (risk-neutral) expectation of the discounted cash flows

Data points for balance sheet-related information from financial statements and regulatory reports are typically available

only on a quarterly basis

Source: George Pennacchi (2010) 7