2014 – year of the CoCo (part 1)

Key points:

1. CoCos are the new form of Tier 1 capital for banks, replacing the old-style step-up securities
2. Issuance has been all offshore to date but is expected to find its way to the AUD market
3. Market is immature but is expected to grow exponentially and could be as large as US$250bn

Contingent convertible capital securities (or CoCos as they are more affectionately known) are the new form of hybrid regulatory capital security under Basel III, replacing the old-style step-up subordinated debt and Tier 1 securities.

The term “contingent convertible” refers to the mechanism that requires the security to either be converted into equity or written off if a pre-defined (contingent) trigger point is hit, most commonly the Core Equity Tier 1 Ratio falling below 5.125%. This is a key feature of (new-style) Basel III compliant regulatory capital securities that will force loss sharing in times of stress, something the previous step-up securities failed to do in the GFC. Recent ASX listed bank hybrids have had this exact clause, although these also have other mandatory conversion to equity clauses.

Like their step-up predecessors, CoCos are typically issued as subordinated debt with a call date (generally five years) and legal maturity date (generally ten years) or as Tier 1 securities with a call date (mainly five years but recent issues had ten year first call period) but perpetual (i.e. no defined maturity date). Further, both the old and new style securities are typically similar in regards to coupons which tend to be mandatory for subordinated debt but discretionary for Tier 1 issues and the ranking in a liquidation scenario is the same between the new and old style.

However, there is no doubting that CoCos are higher risk than the old style step ups predominantly for two reasons:

• CoCos automatically convert to equity or are written off completely if the trigger level is hit. There is no discretion. This mechanism is designed to result in an immediate gain and hence add to retained earnings/capital. In theory, the orderly conversion or write-off of CoCos may produce sufficient capital to return the bank to an appropriately capitalised position and not impact any of the pre-Basel III capital securities such as step-up subordinated debt and Tier 1 securities (although such an orderly improvement in the capital position of a bank once it gets to such levels is unlikely in our opinion)
• CoCos also include a “non-viability” clause which essentially allows the relevant regulator (such as APRA for Australian banks) to force the above conversion into equity or write-off if, at their sole discretion, that bank is at the “point of non-viability”, which is unfortunately not defined. However, an event such as a government injection of capital or bail-out would likely be deemed to be the point of non-viability

So if CoCos are higher risk, why would investors be interested?

Once again there are two main reasons to be interested in CoCos:

• Regulatory changes have forced the change and the simple reality is that there are no more step-up securities being issued. In fact, very little step-up issuance has occurred post-2008 and with many already called or having their first call date in the coming 12 – 24 months, the market is shrinking rapidly. Globally the bank step-up security market is thought to be around US$150bn with the majority expected to be called at first opportunity. This is particularly the case in Australia or more accurately in AUD with very little bank subordinated step-up debt remaining and only a handful of listed and over the counter (OTC) Tier 1 hybrid issues outstanding, most due to be called by 2016. (However, there are a few insurance step-up securities that exist that we will discuss in more detail in the coming weeks)
• Banks, particularly those in Europe, need to raise hundreds of billions of dollars of capital to meet the new Basel III requirements that are being phased up until 2019. And while the majority of that will likely come from share capital, additional Tier 1 (AT1) as it is formerly known is expected to be a significant part of that capital, not only replacing the US$150bn pre-Basel III due to roll-off but also helping banks to meet the higher capital targets, and CoCos are at the forefront of the AT1. Some predict the market to be as big as US$250bn, with issuers such as HSBC, Rabobank, ING, SocGen, Credit Suisse and UBS (and later the Aussie major banks)

In other words, the old style step-ups are few and far between and we have to move into the new reality which will provide far more opportunities to invest.

Importantly, while the CoCos may represent more risk, they also typically come with greater reward in the form of a higher trading margin. Across the 30-odd CoCos that currently exist in USD, € and CHF, trading margins (to call) range from +275bps to as much as +775bps.

Further, significant issuance in 2014 (and beyond) may also create attractive entry points in periods when supply may outstrip demand

In coming weeks we will delve into the different structures of CoCos, together with the ever important technical dynamics (demand and supply) and conclude with our favoured CoCos from a risk-reward perspective. We will also discuss regulatory capital changes and CoCos in the insurance sector.

All investors (AUD or non-AUD, listed/retail or OTC/wholesale) interested in increasing yields should understand CoCos as they are the new form of subordinated and Tier 1 regulatory securities. Technically speaking, any Basel III compliant regulatory capital issue, including recent and future ASX listed bank hybrids, are CoCos. With banks needing to raise hundreds of billions of dollars in capital, 2014 is set to be the year of the CoCo.