Additional Tier 1 (AT1) bonds, previously known as Contingent Convertibles or CoCos have become very popular over the last decade. In this piece, we try to address several frequently asked questions on this topic and talk about different features observed in these bonds.
What Are AT1 Bonds? Who Issues Them?
The essence of these bonds is in the name itself i.e., the bonds are convertible into shares contingent on an event happening. These bonds do not have a maturity and hence are perpetual by nature. All CoCos are perpetual bonds, but all perpetual bonds are not CoCos. The contingent events that lead to a conversion to equity shares are called ‘trigger events’ which refer to the point at which these CoCo bonds have to start absorbing losses. We will cover the different types of trigger events in the subsequent sections. CoCos are primarily issued by banks, but are also issued by insurance companies and non-bank financial institutions. To take the case of banks (since they comprise the majority of CoCo issuances), they have to comply with regulatory requirements like maintaining a minimum specified amount of Common Equity Tier 1 (CET1) capital as a percentage of their Risk Weighted Assets (RWA) as defined by Basel norms.
To access our complete list of CoCo bonds, click here
History of CoCo/AT1 Bonds
CoCos and AT1 bonds are a relatively new product unlike conventional bonds that have been around for centuries. The birth of the now famous CoCo bonds came on the back of the 2007-08 Global Financial Crisis (GFC), which saw several banks getting bailed out amid their balance sheets collapsing with the infamous Lehmann Brothers incident. Lloyds Banking Group issued the first CoCos (which were then known as Enhanced Credit Notes or ECNs) in November 2009, issuing a total of £8.5bn that convert to equity if core capital drops below 5%.
How Are Contingent Convertible Bonds Different From Regular Convertible Bonds?
Regular convertible bonds are bonds issued by a company that can be converted into its shares at the option of the bondholder. CoCos get converted into shares upon the occurrence of a trigger event. Next, convertibles generally come with low coupons as they are a cost effective way to raise funds and give the benefit of the underlying stock’s upside to the investor due to their conversion feature. On the other hand, CoCos are designed as loss absorbing instruments that can get converted into shares when the company is under capital distress. Thirdly, corporations that issue convertible bonds do not have mandatory regulatory capital requirements to fulfil unlike banks.
Are CoCos and AT1 Bonds The Same?
Additional Tier 1 (AT1) Bonds are the most common type of CoCo Bonds. Since banks are the major issuers of CoCos and have to maintain a certain amount of regulatory capital, they issue AT1s, which contribute to their balance sheet as additional capital besides common equity and preference shares – hence the name Additional Tier 1 Bonds. To rank them in order of capital structure seniority, CoCos and AT1s rank junior to all other debt and thereby senior only to ordinary stock, preferred stock and convertible debt. Over the course of this article, we will be using the terms CoCos and AT1s interchangeably since they majorly pertain to banks.
Why Do Banks Issue CoCo/AT1 Bonds?
Banks issue AT1s to shore up their balance sheets with sufficient capital so that losses can be absorbed during times of financial stress without taxpayers bailing them out.
Why Do AT1s Bonds Offer Higher Yields and Pay Higher Coupons?
Given its junior ranking in the capital structure, CoCos pay a higher coupon than traditional bonds and offer higher yields. Besides, since CoCos have a call option, the yield is higher to compensate for the risk of the issuer calling the bond back. To take a case in point, HSBC’s 4.3% bonds due Mar 2026, currently yields 1.6% whereas its 4% Perp callable in Mar 2026 yields 3.8%. Similarly to look at coupons, HSBC issued a 10Y bond in June 2015 with a coupon of 3%. While the market scenario did not change materially, three months later, HSBC issued a CoCo callable in 10 years with a coupon/yield of 6%, twice that of the regular 10Y bond.
What Are The Technical Features And Risks of AT1s?
The key features of CoCos naturally present themselves as risks of investing in them. In this section we highlight in brief with examples, the main features and the inherent risks in these bonds.
These are one of the most important features in the structure of a CoCo that decides when the bonds would get converted into stock. Triggers can be of two types – mechanical or discretionary. Alternatively, the trigger for a CoCo could include both too as we will address further.
These could either be on the basis of book values or market values, both having their own advantages and disadvantages:
Book value triggers are typically set in terms of the book value of Common Equity Tier 1 (CET1) capital as a ratio of risk-weighted assets (RWA) as determined by Basel norms. Since these calculations are not made that often by banks, the frequency of calculation is important in this case. Besides, these could be subject to balance sheet manipulation etc. For example, in the prospectus of HSBC’s USD 6.25% Perp callable on 23 Mar 2023, its Capital Adequacy Trigger Event occurs when the CET1 ratio falls below 7% and conversion is set to be within a month of the occurrence of the trigger.
Market value triggers are set at a minimum ratio of the bank’s market capitalization to its assets. As a result, they can reduce the scope for disadvantage of book value triggers but may be difficult to price and could create incentives for stock price manipulation.
Discretionary Triggers Or PONV Triggers
As per BIS, discretionary triggers are also called Point of Non Viability (PONV) triggers. These are activated based on supervisory authority/regulator making a judgment to prevent the issuing bank’s insolvency. PONV triggers allow regulators to overrule any lack of timeliness or unreliability of book-value triggers, but, can create uncertainty about the timing of activation. For example, in Credit Suisse’s 4.5% AT1/Perp, a perpetual non-call 5Y (perpNC5) issued in November 2020, the bonds have a non-viability trigger event which includes:
- FINMA, the regulator notifies the Issuer that a write-down is necessary to avoid insolvency/bankruptcy or
- Credit Suisse has received an irrevocable commitment of extraordinary support from the public sector without which it would become insolvent or bankrupt
Loss Absorption Mechanism
This is the second feature of CoCos/AT1s. Loss absorption can happen in two ways through which AT1s can boost the issuing bank’s equity – conversion to equity or principal writedown.
Conversion-To-Equity (CE) is a feature that converts bonds into equity shares at a predetermined conversion rate. This conversion rate would be detailed in the prospectus and could be at a pre-specified price or at the market price or both. In the case of HSBC’s 6.25% Perp, the new conversion would happen at what is mentioned as the New Conversion Price (NCP) in their prospectus using a certain formula, shown below from their prospectus:
Principal writedowns (PWDs) reduce book value of debt, hurting CoCo investors while bailing out the company and thereby its equity holders. PWDs could either be permanent, temporary, partial, or total. In the case of BOCOM’s 3.8% Perp, if a non-viability trigger event occurs, BOCOM has the right to irrevocably write-off (partly or fully) the outstanding principal of the bonds and this portion will not be restored or become payable. Besides, any accrued but unpaid distribution of the written-off portion will also not be payable. It is also worth noting that BOCOM’s perp would be written off without an equity conversion feature if there is a trigger event unlike traditional perps issued by Chinese banks which generally come with the conversion feature (say ICBC’s 3.58% Perp which were offshore perpetual preference shares – click here for details on ICBC’s Perp)
Other Features And Risks
Similar to most perpetual bonds, CoCos generally have a call option which lay in the issuer’s hands, not the bondholders. For example, HSBC’s USD 4.7% Perp issued in March 2020 is a Perpetual non-call 10Y (PerpNC10) bond, i.e., it can be called back beginning 9 March 2031 and if not called, the coupon gets reset at the prevailing 5Y US Treasury yield + 325bp. While many investors assume that the bonds will be called, there is no strict reason why they would. If an issuer decides to never call their bonds, investors will only be repaid in coupons perpetually. Alternately, they can try recouping their principal by selling their perpetual bonds in the secondary markets, subject to market liquidity. One example was in February 2019 when Spanish bank Banco Santander chose not to call its 6.25% contingent convertible (CoCo) perpetuals with an amount outstanding of €1.5bn. For Santander, skipping the call made economic sense since the new coupon which kicked-in post the first call date was a floating rate coupon lower than what it would have been if Santander redeemed the bonds and issued new ones.
Since CoCos are callable at the option of the issuer, these bonds generally have a coupon reset equal to the benchmark interest rate plus a pre-defined credit spread if the bond is not called. This could hurt the issuer if the new coupon based on the formula is higher than the existing coupon. But, a coupon reset could also hurt an investor if the new coupon rate is lower than the initial coupon. Early in March 2020, Deutsche Bank said it would hold on to its $1.25bn 6.25% AT1s callable on 30 April 2020 rather than call them back. This happened as the Covid pandemic was on the rise. The bank cited economic reasons in order to manage their cost of funding as the reason for not calling back the bonds. The coupon got reset to 4.789%, or US 5Y Swap Rate + 435.8bp (credit spread) post the event. Deutsche Bank essentially achieved coupon savings of 1.46% (6.25% minus 4.789%).
Some CoCos may also have a coupon step-up besides the reset. A step-up implies an additional coupon increase in the event that the bond is not called on its call date. This might give some cushion to the investor in case the bond is not called. In other words, this coupon step-ups might act as an incentive to call back the bonds.
Dividend Stopper/Dividend Pusher
CoCos also generally have a dividend stopper feature. A dividend stopper is a common covenant seen in perpetual bonds that require the bond issuer to not pay a dividend, if it decides to stop coupon payments on the perpetual bonds. Some CoCos have a clause that allows the issuer to skip a coupon payment at their discretion, if the financial situation of the issuer is stressed. In such cases, a dividend stopper covenant is beneficial to the CoCo bondholders as it restricts the issuer from paying dividends on its equity in times when it has not paid coupon to its CoCo bondholders. BOCOM’s 3.8% Perp had a dividend stopper also attached to it. On the flipside, are dividend pushers which are a covenant seen in perpetual bonds issued by both banks and corporates that require the issuer to make a coupon payment if it has paid a dividend on its shares.
Capital Structure Subordination
AT1s/CoCos as mentioned earlier, rank junior to all debt and thereby senior only to ordinary stock, preferred stock and convertible debt. Hence in the event of liquidation, CoCo holders will be paid only after claims of all its senior creditors are paid.
In this case, issuers have the right to pay coupons at its sole discretion without it being an obligation. With this feature, holders also face a possible risk of not receiving a coupon payments during the life of the bond. For example, HSBC’s 6.25% Perp has a discretionary coupon clause which notes that “any interest cancelled or deemed to have been cancelled (in each case, in whole or in part) pursuant to such Sections shall not be due and shall not accumulate or be payable at any time thereafter”.
In conclusion, it is likely that you would have come to understand that CoCos/AT1s are attractive for an investor since they offer a higher yield than traditional bonds. But as highlighted above, the higher returns come with higher risks associated with them. As investors, it would be useful to have a checklist across the points detailed in the article like the bond rating vs. issuer rating, coupon resets, trigger events, coupon step-ups etc. before making an investment decision on buying CoCos. These details are available in the bond’s prospectus for investors to analyze.
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