EU protection plan boosts investor appeal of ‘CoCos’

Banks’ riskiest bonds may move higher on investors’ shopping lists as the European Union simplifies regulation of the securities and softens restrictions on coupon payments.
The European Commission, the EU’s executive arm, has proposed boosting protections for holders of contingent convertible bonds, or CoCos, a type of asset that has become increasingly difficult to price as regulations pile up, according to bankers, analysts and investors.
“The new EU proposals will help rescue a useful and important type of capital that had been undermined by an excess of complexity and good intentions,” said Wilson Ervin, Credit Suisse Group’s former chief risk officer who’s now vice chairman of the Group Executive Office at the Zurich-based bank.
Regulators dreamed up CoCos after the 2008 financial crisis as a way of helping banks bolster capital ratios by tapping debt investors. Also known as additional Tier 1 bonds, CoCos must have no stated maturity and have to convert into equity automatically or be written down to absorb losses if the issuer’s capital ratios drop below a threshold. On top of this, interest payments are optional, the feature that’s caused most confusion among investors.
That confusion became apparent in the first quarter when concern emerged that calculations of available cash - known as the “maximum distributable amount,” or MDA - might block interest payments by some issuers. Equity prices plunged, yields on CoCos soared and issuance dried up, casting doubt on the future of the market.
“The original design concept for contingent capital was fairly straightforward: subordinated debt that paid a decent coupon in most (good) scenarios, and which converted into equity in distressed downside scenarios,” Ervin said by e-mail. “Over time, different regulations like MDA distribution restrictions, combined buffer requirements, national accounting rules and other technicalities made the instrument increasingly complex and hard to value.”
Current EU law ranks CoCo coupons equally with other discretionary payments such as dividends and bonuses. In an undated discussion paper obtained by Bloomberg News, the Brussels-based commission proposes making the preference explicit. Banks would only be able to pay stock dividends if such coupons are paid in full, according to the document.
“I think it’s a sensible and logical move from regulators which will serve to restore the proper hierarchy within the capital structure,” said Paul Smillie, a Singapore-based analyst at ColumbiaThreadneedle, which manages about $446bn globally. “It’s a positive for the AT1 market broadly and for the ability of the European banks to issue these instruments.”
Putting AT1 coupons at the head of the queue for payment comes on top of a proposal that effectively lowers the threshold at which restrictions kick in. It’s part of a rule overhaul in which the commission is reining in supervisors’ powers to impose capital requirements exceeding the legal minimum, known as Pillar 2, a crucial factor for payout limits.
“In reality, all those conditions and triggers are so complex that at the end of the day nobody knows whether or not banks are able to pay coupons,” said Francois Lavier, who oversees about $3.4bn of bank debt at Lazard Freres Gestion in Paris. “The capital saving of not paying coupons is so low that I think the calculations were clearly too complex for such little benefit.”
The commission began to soften its stance in March, with a paper that suggested splitting Pillar 2 into binding requirements and non-binding “guidance.”
The European Central Bank, the supervisor of the biggest banks in the euro area, has already adopted it.
When calculating whether they have the funds to make a payout, lenders don’t need to consider the ECB’s capital guidance, in effect giving them more room to make discretionary payments.
“For sure it looks like the regulators are trying to be a bit softer on the asset class after the mini-scare in February,” said Otto Dichtl, an analyst at investment manager Stifel Nicolaus Europe Ltd “It could reduce volatility, although I suspect investors won’t be too keen to hold on to the most subordinated bond instruments of a bank which just reported losses large enough to breach regulatory capital expectations.”
Concern that some banks might have insufficient capital to pay coupons on their CoCos rocked the market in the first quarter of this year, pushing the mean price of bonds on Bank of America Merrill Lynch’s CoCo Index to as low as 88.8 cents on the euro from a 2015 high of 104.6 cents. The price has now rallied to 99.47 cents, just below par value.
“A little while ago it seemed as if this young asset class was already past its prime, but we now think that the Pillar 2 clarifications and the commission’s current proposals could drive sustainable market growth,” said Philipp Jaeger, a fixed income analyst at Berenberg Bank. “We welcome the commission’s proposals, because giving CoCo coupons preference to stock dividends would resemble the existing insolvency hierarchy.”
To be sure, it would be wrong for investors to conclude that coupon risk would be completely removed for CoCos, said Samuel Theodore of Scope Ratings in Berlin.
“Some investors’ guard may drop and the scenario of coupon non-payment may disappear beyond the horizon line of their concerns,” Thedore said in a note. “That would be in our view a mistake, especially as going forward we expect a larger number of banks – not all in top financial condition – to start issuing AT1.”