No CoCos, Please, We’re British

Retail investors in the UK have been barred from buying Contingent Capital instruments:

The U.K.’s Financial Conduct Authority will ban firms from selling contingent convertible bonds to individual investors, saying they’re too complex and risky for the mass retail market.

From Oct. 1, the FCA will limit sales of CoCos to institutional, professional investors and high-net-worth individuals for 12 months, the London-based regulator said in a statement today. The FCA will publish a consultation paper on a set of permanent set of rules for CoCos in September.

“In a low interest rate environment, many investors might be tempted by CoCos offering high headline returns,” Christopher Woolard, the FCA’s director of policy, risk and research, said in a statement today. “However, they are complex and can be highly risky.”

“Every time a bank gets into trouble and you have retail investors in subordinated debt or CoCos, it gets difficult and embarrassing for the regulators,” said Mark Taber, who helped organize a group of individual holders of Co-Operative Bank Plc bonds when the British lender was restructured following a capital shortfall. “They don’t want to have that problem every time that happens. They want to be able to deal with banks.”

Their press release states:

Temporary product intervention rules are made without prior consultation and thus will not undergo the usual process for testing draft rules and receiving feedback from the public before they are made. While every effort has been made to ensure these temporary rules have the effect described in this communication, we remain aware of the possibility of unintended consequences.

In a linked document the European Securities and Markets Authority acknowledges (emphasis added):

Investors should fully understand and consider the risks of CoCos and correctly factor those risks into their valuation. To correctly value the instruments one needs to evaluate the probability of activating the trigger, the extent and probability of any losses upon trigger conversion (not only from write-downs but also from unfavourably timed conversion to equity) and (for AT1 CoCos) the likelihood of cancellation of coupons. These risks may be highly challenging to model. Though certain risk factors are transparent, e.g., trigger level, coupon frequency, leverage, credit spread of the issuer, and rating of instrument, if any, other factors are discretionary or difficult to estimate, e.g. individual regulatory requirements relating to the capital buffer, the issuers’ future capital position, issuers’ behaviour in relation to coupon payments on AT1 CoCos, and any risks of contagion. A comprehensive appreciation of the value of the instrument also needs to consider the underlying loss absorption mechanism and whether the CoCo is a perpetual note with discretionary coupons (AT1 CoCos) or has a stated maturity and fixed coupons (T2 CoCos). Importantly, as one descends down the capital structure to sub-investment grade where the majority of CoCos sit, the level of precision in estimating value when compared to more highly rated instruments, deteriorates. ESMA believes that this analysis can only take place within the skill and resource set of knowledgeble institutional investors.

The FCA action comes at a time when investor appetite is very high:

Denmark may be forced to amend its policy on how much hybrid debt banks can use to meet capital requirements after European regulators recommended limits.

The European Banking Authority in London is proposing that contingent convertible debt make up no more than 44 percent of the additional capital that national regulators tell the banks they oversee to hold. The so-called Pillar 2 capital is used to address risks not covered by minimum European Union requirements.

Nykredit said in May it expected its 600 million-euro ($805 million) Tier 2 CoCo to be eligible for use as both Pillar 1 and Pillar 2 capital. The lender said at the time it “may be tempted to sell more” following investor demand. The bond, which has a coupon of 4 percent, yielded 3.63 percent today in Copenhagen trading, little changed from yesterday.

Danske sold a 750 million-euro Additional Tier 1 note in March with the intention that the security could be used to meet Pillar 2 requirements, Claus Jensen, the bank’s chief investor relations officer, said by phone. The 5.75 percent note yielded 5.32 percent today, versus 5.33 percent yesterday.

In a Financial Times, piece, Alberto Gallo, head of macro-credit research at RBS, writes:

The worry is that some buyers may not understand the differences and risks of coco structures. Around a fifth of buyers are private clients, and this proportion could rise as the market goes mainstream: the first bond index for cocos was recently initiated by Bank of America Merrill Lynch.

In its last Financial Stability Report, the Bank of England mentioned the investor base for cocos had broadened, but warned that “investors were placing insufficient weight on the likelihood of a conversion being triggered”.

An analysis of existing coco bonds published by RBS shows prices only compensate for the coupon deferral risk, not for potential losses from conversion. Finally, Tobias Berg of Bonn University and Christoph Kaserer of Munich Technical University recently suggested cocos could push banks to take more risk, given their asymmetric risk-return profile with losses skewed towards investors.

No one really knows what would happen if a bank were to suspend its coupon payments, or worse, had to convert its cocos. Several investors fear this could compound volatility or even disrupt the whole market: some already predict 10 percentage point price drops the first time a bank hits a trigger on its cocos.

Regulators must act now to avoid waking up to these problems when it is too late. The first thing to do is flag clearly that cocos are not regular bonds, before investors unaware of the risks start buying. The case of Bankia’s bail-in in Spain highlighted the social pain of pushing losses on to bonds held by retail investors. Cocos can expose holders to cliff-like losses: they are not for orphans or widows.

Second, regulators need to create standards and reduce complexity across jurisdictions, clarifying how triggers and conversion mechanisms really work in a crisis. In doing so, they should favour instruments where the risks and rewards are aligned with shareholders, like cocos that convert into and dilute equity in case of losses, and discourage writedown cocos, where bondholders crystallise losses but get no upside.

All this is happening as Barclays starts marketing a CoCo index:

“CoCo issuance has steadily grown in recent years and we anticipate further expansion of this market as financial institutions issue these bonds to help achieve required regulatory capital ratios,” said Brian Upbin, Head of Benchmark Index Research at Barclays. “Though CoCos are not eligible for broad-based bond indices such as the Global Aggregate, there are debt investors who hold these securities as out-of-index investments and need a benchmark of asset class risk and returns.”

The Barclays Global Contingent Capital Index includes hybrid capital securities with explicit equity conversion or writedown loss absorption mechanisms that are based on an issuer’s regulatory capital ratio or other explicit solvency-based triggers. Subindices by currency, country, credit quality, and capital security type are available as part of this family. Bespoke credit and high-yield indices that include traditional hybrid capital as well as contingent capital securities are also now available with this expanded security coverage. The inception date of this index is May 1, 2014, and the index universe contains 65 CoCo issues with a market value of $98bn as of May 31, 2014.

Barclays also indicates:

“Though CoCos are not eligible for broad-based bond indices such as the global aggregate, there are debt investors who hold these securities as out-of-index investments and need a benchmark of asset class risk and returns,” he [Brian Upbin, head of benchmark index research at Barclays] said.

Barclays plans to exclude securities with conversion features based solely on the discretion of local regulators, those that have an additional equity conversion option based on regulatory or solvency criteria, inflation-linked bonds and floating-rate issues, private placements and retail bonds, and illiquid securities with no available internal or third-party pricing source.

Update, 2014-8-14: It has just occurred to me that this is somewhat akin to Canadian ABCP – where vendors (completely voluntarily and not with a regulatory gun to their heads at all, definitely not) compensated retail investors who lost money. At least the FCA has the decency to ban things before they go wrong … even though it means won’t get a Canadian-style slush fund out of it.

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