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The Pricing of already issued Contingent Convertible Bonds (CoCo-Bonds)

Seminar Paper 2011 23 Pages

Business economics - Banking, Stock Exchanges, Insurance, Accounting

Excerpt

Contents

List of Figures

I Introduction

II The mechanism of CoCo-Bond
2.1 Backgrounds and functionality
2.2 Definition of the Trigger Event
2.2.1 The Market Trigger
2.2.2 The Accounting Trigger
2.2.3 The Regulatory Trigger
2.2.4 The Multi-Variante Trigger
2.3 The Specification of a Conversion
2.3.1 The conversion fraction ( )
2.3.2 The conversion ratio Cr and the conversion price Cp
2.4 The Specifications of already issued CoCo-Bonds

III The Pricing of CoCo-Bonds
3.1. Introduction
3.2. The Credit Derivatives Approach
3.2.1 The Loss
3.2.2 The Trigger Intensity Trigger
3.3. The Equity Derivative Approach
3.3.1 The Pricing of a Zero Coupon CoCo-Bond
3.3.2 The Pricing of a CoCo-Bond with Coupons
3.4 Calculation Examples on the Basis of already issued CoCo-Bonds
3.4.1 Example for the Credit Derivatives Approach (Case Study Credit Suisse)
3.4.2 Example for the Equity Derivatives Approach (Case Study Lloyds)

IV Conclusion

Appendix

References

List of figures

Figure 1: Summary of the specifications of the already issued CoCo-Bonds

Figure 2: The Loss of a CoCo-Bond when hitting the Trigger

I Introduction

In the year 2007 one of the biggest financial crisis in worlds history has begun. It leads to the bankruptcy of huge financial institution followed by the bailout of banks through the national government and a downturn in worldwide stock markets. The financial crisis has also shown that the capitalizations of numerous financial institutes were not adequate and several components of banks equity could not fulfil their planned function. To save the global financial system from collapsing many banks received lot of money from the government.

To avoid another future crisis and huge bailouts by the national government, some financial experts and leading economists proposed a new financial instrument, called Contingent Convertibles Bonds (“CoCo-Bonds”). They are considered to be an opportunity to improve the equity base of banks in times of crisis.1 CoCo-Bonds are a special form of bonds, which convert automatically to equity after a predefined incidence.

Three large banks have already issued these new financial instruments; The Lloyds Banking Group (2009), Rabobank (2010) and the Credit Suisse (2011). The aim of this paper is to analyse the structure and the pricing of these already issued CoCo- Bonds. In the first part the functionality of the CoCo-Bonds will be explained. It will also provide a summary of the specification of the already issued CoCo-Bonds. The third part, which is the main part, is focused on the pricing modalities of these new financial instruments. Two different approaches will be considered. First the credit derivatives approach and seconds the equity derivatives approach. In the end of the paper both approaches will be applied to the already issued CoCo-Bonds of Lloyds and Credit Suisse.2

II The Mechanism of CoCo-Bonds

2.1 Backgrounds and functionality

As mentioned in point I CoCo-Bonds convert automatically by reaching a predefined incidence. In case of a conversion the investor of a CoCo-bond receives shares of the emitting institution. If the conversion doesn’t take place the CoCo-Bonds will be amortized after maturity, such as a common bonds. So they take up an intermediate position between dept and equity capital. Because of this characteristic they are so- called hybrid financial instruments, such as traditional convertible bonds.3

Contrary to traditional convertible bonds - by which the holder has the right to decide if the bond should convert into equity or not - the conversion of a CoCo-Bond takes place automatically due to a predefined incidence. Therefore the holder must accept the conversion or rather the Debt-Equity-Swap and the initial creditor turns into an equity holder. Through the conversion the equity capital base is improving although there is not cash flow actually. In addition to that the interest expense also decreases because of the reduction in dept capital. In case that the market conditions deteriorate and the financial institute cannot improve their capital base by emitting new shares anymore, the recapitalization ensures from bankruptcy. Intention is to avoid the need for governmental intervention and to create the opportunity for internal refinancing.4 In case of a conversion it will come to dilution of equity for the existing shareholders, so the would have the more incentive to control the readiness to assume risk from the management.5

The trigger, which activate the conversion from dept to equity capital, could be defined differently, e.g. if the stock prices falls under a certain barrier. The different modes for the trigger event will be described under the next point. In contrast to common convertible bonds, which are already described in literature extensively, the analysis in regard to CoCo-Bond has just begun. Flannery proposed this instrument at first in the year 2002 and after a revised version in 2009 he called this special bonds “Reverse Convertibles Debentures”.6 The Squam Lake Working Group, consisting of 15 American economists also supports the appliance of CoCo-Bonds for financial stabilization.7 The Basel Committee on Banking Supervision has taken on the pioneering role of research relating to CoCo-Bonds, because of the planned new regulations under Basel III.

2.2 Definition of the Trigger Event

Essential for the application of CoCo-Bonds is the definition of the trigger event, which actuates the conversion from dept to equity capital. However the determination of the trigger is really complex, because various possible impacts must be considered. The transparency, clarity and objective of the trigger is vitally important. In literature three different modes of trigger can be defined: the market trigger, the accounting trigger and the regulatory trigger. Furthermore there are considerations to combine different kinds of trigger to a multi-variate trigger.8

2.2.1 The Market Trigger

Proposed by Flannery one opportunity is the application of market values for the trigger event. The conversion would take place automatically if the share price falls under a predefined barrier. Alternatively also CDS prices could serve as trigger event.9 One central argument for the adoption of a market trigger is the objective of market prices. The requirements for transparency and clarity are also comply with the choice of market prices for the trigger event, because share prices could be observed at any time without much effort.10 In addition to that market prices are always up-to- date. With the choice of market prices for the trigger event the conversion is dependent on the behaviour and expectations of the market, which determinates the prices for share or CDS. So the conversion wouldn’t fall to the valuation of a regulatory instance.11

However market prices have the disadvantages that a conversion could take place, even though the equity base of the underlying financial institute isn’t that bad. Moreover the more problematic scenario is when the equity base would need the new capital but the market trigger isn’t reached so far. This scenario could be a result of asymmetric information during a crisis.12 The volatility of stock markets or even market failure should also be considered. Especial the Behavioural Finance Research has identified that market participants could act quite irrational and as a result the theory of market efficiency must be scrutinised. Last but not least the opportunity for market price manipulation is another point of critique. The share price could be manipulated to profit by the conversion into equity capital.13

2.2.2 The Accounting Trigger

Another alternative is a trigger based on the regulatory equity base. The trigger is either based on the Common Equity Capital or on the Core Tier I Capital. In view of the intended function of CoCo-Bonds, namely the reinforcement of the financial resources during a crisis, this kind of trigger is obvious. The Swiss Commission of Experts also recommends this choice of the trigger event. So the conversion would take place if a predefined Common Equity ratio falls below a certain barrier. Essential for the function is the decided barrier level, because the probability of conversion is based on it. If the Common Equity ratio of 7 % effects the conversion the probability of a trigger event is relatively high. It’s a so-called high trigger event, because the regulatory minimum standards for the capitals requirements of a bank could still be fulfilled.

A CoCo-Bond with a high trigger event is therefore used for stabilization of the institute before any reorganisation measures. At the same time the recapitalisation should ensure the reliance in the capital market.14 A conversion based on a lower trigger event, such as a Common Equity ratio of 5 %, has a relatively low probability of conversion. CoCo-Bonds with a lower trigger convert into equity capital solely during a crisis, so this design of the CoCo-Bond could help towards the financial restructuring.15 Beside a trigger event based on the regulatory equity capital a trigger could also be rest on balance sheet ratios. In this regard the possible scope in the valuation of accounting values is often criticised. The actuality of the ratios and equity capital quotes are also debatable, because they are only issued quarterly. In times of a crisis the CoCo-Bond could convert too late.16 For example the Tier 1 ratio of Lehman Brothers were fare above the minimum level before the collapse.

2.2.3 The Regulatory Trigger

There are also intentions, that the decision for a conversion should be delegated to the respective national instance for bank supervision. If they determine that a financial institute is in trouble and probably couldn’t fulfil the financial obligations any more, the conversion would be arranged. For example Stresstests cloud also be the foundation of the decision. The Basel Committee of Banking Supervision also recommends a regulatory trigger. They describe two situations, where the national instance for bank supervision should originate the conversion; if they have the opinion that the financial institute isn’t survivable without depreciation of obligations and if the survivability of the institute depends on governmental aid.17 In contrast to trigger events based on capital ratios the regulatory trigger could be updated frequently, for example with special audits, this is an advantage of the described trigger event. Also the risk of market manipulation of the market trigger could be avoided through the regulatory trigger.

However the estimation of the probability of the trigger event is very difficult. This fact could lead to uncertainty among the investors due to the risk of conversion and therefore to higher coupons or costs for the emitting institute. Because of the difficult way to predict to trigger event, the rating agency Moody’s will refuses to rate this kind of CoCo-Bonds.18

2.2.4 The Multi-Variante Trigger

The Squam Lake Working Group proposes also a trigger, which takes place in case of an achievement of two criteria. So for a conversion it cloud be necessary that the national instance of banking supervision announces that the financial systems is in crisis and at the same time some predefined covenants are infringe. In this spirit the trigger is made up of an institutional and a systemic specific component. This specification leads to the fact that a financial institution cannot relay on a supporting conversion in case of trouble. Through this misguiding incentives from the management should be avoid.19

The multi-variante trigger also provides a comprehensive recapitalization in case of a crisis in consideration of the institutional specific situation. However the inherent disadvantages of both components are still upstanding. Disadvantages like the dependence on the decision of the national banking supervision and the lag in time by valuation of the accounting values.20 Another question arises by choosing the right point of time for a conversion and the associated function of the CoCo-Bonds. In the way mentioned above they would be converted amidst a crisis, so they would act as last aid against a bankruptcy.21

2.3 The Specification of a Conversion

CoCo-Bonds have different specifications in reference to the potential conversion. They could be different in terms of the conversion fraction, the conversion ratio (Cr) and the resultant conversion price (Cp).

2.3.1 The conversion fraction ( )

The conversion fraction ( ) is the measure of CoCo-Bonds, which will be converted into shares in case of the trigger event. The amount of CoCo-Bonds, which should be converted, is given by the conversion fraction times the face value N of the CoCo- Bond. The resulting crucial question is how should be defined. The Shadow Financial Regulatory Committee favoured the conversion of all outstanding CoCo- Bonds ( = 1) in times of crisis. They are of the opinion that only converting enough shares to rescue the financial institute from collapsing won’t bring back the reliance in the financial market. Of course there are also experts, which recommend a fraction of < 1.22

[...]


1 Flannery (2009), p. 2 f

2 De Spiegeleer/Schoutens (2011), p. 1

3 DB Research, http://www.dbresearch.com/PROD/DBR_INTERNET_EN- PROD/PROD0000000000273597.pdf, 30.04.2012

4 Manager magazin online, http://www.manager-magazin.de/finanzen/boerse/0,2828,744409,00.html, 30.04.2012

5 Collender/Pafenber/Seiler (2010), p. 20

6 Flannery (2002), p. 2 f.

7 Squam Lake Group (2010), p. 86 ff.

8 De Spiegleer/Schoutens (2011), p. 3-4

9 Flannery (2002), p. 11

10 DB Research, http://www.dbresearch.com/PROD/DBR_INTERNET_EN- PROD/PROD0000000000273597.pdf, 30.04.2012

11 DB Research, http://www.dbresearch.com/PROD/DBR_INTERNET_EN- PROD/PROD0000000000273597.pdf, 30.04.2012

12 McDonald (2010), p. 20

13 Kamada (2010), p. 33

14 Schweizer Expertenkommision (2010), p. 26

15 DB Research, http://www.dbresearch.com/PROD/DBR_INTERNET_EN- PROD/PROD0000000000273597.pdf, 30.04.2012

16 Schweizer Expertenkommission (2010), p. 35

17 IMF (2011), http://www.imf.org/external/pubs/ft/sdn/2011/sdn1101.pdf, 30.04.2012

18 IMF (2011), http://www.imf.org/external/pubs/ft/sdn/2011/sdn1101.pdf, 30.04.2012

19 Squam Lake Group (2010), p. 91

20 IMF, http://www.imf.org/external/pubs/ft/sdn/2011/sdn1101.pdf, 30.04.2012

21 McDonald (2010), p. 7 f.

22 De Spiegeleer/Schoutens (2011), p. 6

Details

Pages
23
Year
2011
ISBN (eBook)
9783656347309
ISBN (Book)
9783656347378
File size
746 KB
Language
English
Catalog Number
v207354
Institution / College
University of Innsbruck – Banking and Finance
Grade
1,2
Tags
CoCo-Bonds contingent convertibles financial ciris pricing alrealy issued Credit Derivatives Approach Equity Derivative Approach

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Title: The Pricing of already issued Contingent Convertible Bonds (CoCo-Bonds)