Table Of ContentMARCIN LIBERADZKI
AND KAMIL LIBERADZKI
Instruments, Regulation, Management
Contingent Convertible Bonds, Corporate Hybrid
Securities and Preferred Shares
Marcin Liberadzki • Kamil Liberadzki
Contingent
Convertible Bonds,
Corporate Hybrid
Securities and
Preferred Shares
Instruments, Regulation, Management
Marcin Liberadzki Kamil Liberadzki
Department of Finance Department of Finance
Warsaw School of Economics Warsaw School of Economics
Warszawa, Poland Warszawa, Poland
ISBN 978-3-319-92500-4 ISBN 978-3-319-92501-1 (eBook)
https://doi.org/10.1007/978-3-319-92501-1
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Preface
This book is a comprehensive monograph devoted to the new generation of
hybrid securities: contingent convertibles (CoCos) issued by banks and insur-
ers, banks’ subordinated bail-in bonds, insurers’ subordinated bonds, hybrid
securities issued by non-financial entities (so-called corporate hybrids) and
US banks’ preferred stock that form a new class (tier) of Basel III regulatory
capital: Additional Tier 1 (AT1).
The ‘new-generation’ hybrids mean fixed income securities that possess
characteristic of both debt and equity, being neither of them. They are placed
in the ‘debt-equity continuum’ as credit rating agencies name it. The idea of
hybrid securities alone is not new. However, the last one and a half decades
saw a significant development it this assets’ class in terms of new-style hybrid
instruments having come up that merger into one single instrument the whole
bundle of already present clauses elsewhere such as: (1) subordination to all
issuer’s other debt, (2) very long tenors or no maturity date at all (albeit with
issuer’s call option typically not exercisable until 5 to 10 years after the date of
issuance), (3) coupon reset mechanism (usually fix-to-float with a step-up or
fixed-to-reset) and (4) coupon deferral. The first new-generation corporate
hybrids were issued around 2003. At first glance, they are coupon-paying,
normal subordinated debt securities to retire at maturity (unless they are per-
petual bonds). However, they become less debt-like when issuer falls into
financial distress. Their loss-absorption capacity occurs in terms of ranking
below all other debt but above equity in case of liquidation or winding-up of
the issuer. The deep subordination along with ability not to pay a coupon or
notional brings them closer to equity instruments. In contrast, with the pure
debt coupon must be paid regardless of the issuer’s financial condition, and
the same holds true regarding the repayment of debt face value when the debt
v
vi Preface
reaches maturity. In other words, in times of financial stress hybrids offer flex-
ibility of equity instruments without diluting voting rights of existing
shareholders.
Another, this time totally new dimension of hybrids occurred with the
advent of worldwide recognized Basel III Capital Accord in 2011. It is a con-
version to a more deeply subordinated instrument (contingent conversion) or
write-down of the principal value of the hybrid bond upon the occurrence of
a stress event. These force the hybrid security to absorb loss while the bank
remains a going concern, without undergoing a bankruptcy or restructuring.
The global financial crisis of 2007–2009 showed that banks relied too much
on debt financing and a capital buffer was highly needed to absorb losses in a
manner that would not force regulators to bail out banks with public money.
That is why the Basel III set new prudential capital requirements for banks
increasing level of banks’ equity. Apart from genuine equity (i.e. shares,
retained profits and reserves), the present regime allows for other instruments,
in the form of the contingent capital notes, to be included as bank capital.
These are called contingent convertibles (CoCos). CoCos are hybrid securities
with an automatic conversion provision which enables banks to exchange
bonds for common stock, subject to a breach of a conversion trigger set forth
at the inception of the issuance of the bonds. Unlike with regular convertibles,
a conversion is not an option at the discretion of a bondholder but is forced
when regulatory capital fails to meet a predetermined level. Despite their
name, CoCos may present a more extreme construction of loss absorption
imprinted in a write-down mechanism, where the occurrence of a predeter-
mined stress-event automatically triggers a write-down of a bond’s value with-
out diluting shareholders. The burden of an institution’s failure is imposed on
the bondholders, but the institution may continue to operate, averting dis-
ruption of the financial system. Chapter 1 offers an insight into CoCos issued
by European Economic Area (EEA) banks. With only few exceptions,
European CoCos date no earlier than 2014. This analysis is combined with
basic analysis of EEA banks’ capital data, as it is crucial to assess risk of trigger
event and coupon cancellation.
In addition to automatic trigger mechanism based on regulatory capital
ratio level, European Union’s (EU) competent resolution authorities are
granted discretionary power to start write-down or conversion and determine
its exact scope on reaching the point of non-viability (PONV) that marks an
institution is ‘failing or likely to fail’. Unlike with automatic CoCo trigger, the
determination that a bank is no longer viable has not been well defined in a
way that it could explicitly be translated into a strict quantitative measure, say
a level of capital adequacy ratio. Notably, the main controversy is that PONV
Preface vii
may occur before a bank’s capital ratio falls to the trigger level. These two trig-
ger mechanisms are effective parallelly and their interrelation is the subject of
detailed study in Chap. 2. Distinctively, the PONV power goes beyond AT1
CoCos and refers to virtually all classes of bonds including the senior ones.
The PONV loss-absorption mechanism that came with the new EU’s resolu-
tion regime in 2014 is a determinant for the whole ‘bail-in’ bonds class. In
Chap. 2 we examine the subordinated bail-in bonds in the form of Tier 2 and
new class of non-preferred senior instruments. The general concept of bail-in
bonds led to the introduction of total loss-absorption capacity (TLAC) for
globally systemically important banks and minimum requirement for own
funds and eligible liabilities (MREL) for all EU banks in 2014, which is
referred to in Chap. 2.
Investors in contingent capital facilities prefer consistent and high coupon
payments to equity stakes. As a rule, they anticipate that the triggers will never
be reached and therefore enjoy a relatively high coupon that embodies the
option to convert the bond into equity (i.e. spread plus premium of the
option). The AT1 CoCos credit spread calculation is a challenging task con-
sidering numerous clauses embedded in this security. Apart from risk of trig-
ger event occurrence, holders of AT1 CoCos are exposed to risks of coupon
cancellation and call extension. The complexity of CoCos is amplified by the
fact that the triggering may be caused not only by the occurrence of contrac-
tually determined trigger events, but also by the behaviour of the supervision
or resolution authority. Their pricing models have been classified into market
and structural models. The most prominent among the market models are
credit derivatives and equity derivatives model. Chapter 3 presents these mod-
els together with the implied CET1 volatility model in more detail as an
example of structural approach. Further sections present our empirical analy-
sis using a dozen of regressors for explaining ‘spread to Tier 2’ observable values.
In Chap. 4 we present CoCos issued by selected non-EEA countries’ banks
for the same purposes of fulfilling Basel III regulatory capital requirements.
The focus is on underlining main differences between EEA banks’ and non-
EEA banks’ CoCos.
We then look into insurers’ Tier 1 Solvency II regulatory package compliant
CoCo bonds. Like banks, insurers are part of regulated industry. Banks’ and
insurers’ CoCos present very similar debt characteristics under Solvency II and
Basel III. Most notably, they both have a loss-absorbency mechanism on a
going-concern basis, which is based on a regulatory capital ratio trigger event.
We then compare Tier 2 bonds issued by insurers to those issued by banks. Tier
2 bonds are plain vanilla bonds similar to those issued by European banks.
Both of them are subordinated to senior unsecured debt. This chapter con-
cludes with presenting main features of insurers’ Tier 3 bonds.
viii Preface
The final chapter of this book is on corporate hybrid securities, namely
hybrids issued by non-financials, that is, other than banks and insurers. Unlike
CoCos, they lack the contingent conversion or write-down loss-absorbing
feature. We concentrate on the market performance of hybrids issued by
Volkswagen in the scenario of a corporate governance scandal that broke out
in September 2015. As the corporate hybrids market is relatively young and
dominated by ‘blue chip’ issuers, the VW ‘dieselgate’ offered the rare oppor-
tunity to observe the real-world behaviour of such instruments class when an
issuer is likely to defer scheduled coupon payments.
Finally, we take broader look at the non-voting preference shares. Although
nominally considered to be full-fledged equity, they are in fact placed in debt-
equity continuum only slightly closer to common equity than bond-based
corporate hybrids. Remarkably, preferreds carry debt-like features as they are
stripped of the voting rights and, in particular as with US preferreds, they pay
dividend on a regular basis. As such, they are deemed ‘fixed income’. The
newest class are preferreds issued by US banks to fulfil the Basel III regulatory
AT1 capital requirements. The US Dodd-Frank rules differ in this respect
from the EU regulatory framework. In particular, US banks’ AT1s do not
have a ‘going-concern’ loss-absorption mechanism embedded in the form of
contingent conversion into shares of common stock or write-down.
What makes this book distinctive is, in our opinion, its comprehensive and
in-depth approach to all the modern types of hybrids throughout the world.
Although concentrated on EU rules, in no way does this analysis constrain to
Europe; it refers to other various jurisdictions as US or selected countries of
Asia-Pacific region. This is our second book on hybrid securities issued world-
wide. Those readers familiar with our previous Hybrid Securities. Structuring,
Pricing and Risk Assessment monograph of 2016 (also with Palgrave Macmillan)
will find this book complementary to the 2016 publication. It is not only in
a sense that this book is a continuation and, what obvious, an update of the
previous one, but it offers improved and more in-depth analysis especially in
terms of EEA AT1 CoCos as well as PONV parameterization. Besides, it adds
study on Asia-Pacific CoCos and US AT1 preferreds.
Warszawa, Poland Marcin Liberadzki
Kamil Liberadzki
Contents
1 Contingent Convertibles Issued by EEA Banks 1
2 CoCo Bonds and Bail-in Mechanism 83
3 The Contingent Convertibles Pricing Models: CoCos Credit
Spread Analysis 123
4 Non-EEA Banks’ and Insurers’ CoCos 149
5 Corporate Hybrid Securities and Preferred Shares 167
Bibliography 211
Index 223
ix
Abbreviations
ADI Available distributable items
AGM Annual general meeting of shareholders
APRA Australia Prudential Regulation Authority
AT1 Additional Tier 1
BaFin (Bundesanstalt für
Finanzdienstleistungsaufsicht) Federal Financial Supervisory Authority
BCBS Basel Committee on Banking Supervision
BIS Bank of International Settlements
BRRD EU Bank Recovery and Resolution Directive
CAB Capital access bonds
CAR(1) (Tier 1) Capital Adequacy Ratio
CB Convertible bond
CBR Combined buffer requirement
CBRC China Banking Regulatory Commission
CCAR Comprehensive Capital Analysis Review or CET1
Capital Adequacy Ratio
CCB Capital conservation buffer
CDS Credit default swap
CE CoCos Conversion to equity contingent convertibles
CET1 Common Equity Tier 1
CoCo Contingent convertibles
CRD IV The fourth Capital Requirements Directive
CRR Capital Requirements Regulation
DB Deutsche Bank
DECS Debt Exchangeable for Common Stock or
Dividend Enhanced Convertible Securities
DFAST The Dodd-Frank Act Stress Test
DI Distributable items
xi
