European banks are set to issue an “avalanche” of contingent convertible bonds next year in order to assuage worries over capital requirements and leverage ratios.
Contingent convertible – or coco – bonds were created in the aftermath of the 2008-09 financial crisis to absorb bank losses and avoid the need for taxpayer bailouts. Some cocos convert into equity when a bank’s capital ratio falls below a pre-agreed trigger. Others can be written off entirely.
With European regulators’ stress tests putting pressure on banks to build adequate buffers against losses, incoming Basel III capital ratios, and concerns over excessive leverage, banks are set to issue more cocos in response.
“There will be an avalanche of additional tier one cocos next year from European banks as banks build capital buffers and improve their leverage ratios,” said Gerald Podobnik, head of capital solutions at Deutsche Bank.
Tier one capital, a key regulatory measure of financial health, is considered the safest portion of a bank’s capital and traditionally comprises common shares and retained earnings. It is also used in calculating leverage ratios when compared to banks’ total assets.
European banks, including Barclays, KBC, Credit Suisse and UBS, have issued a record $9.6bn worth of cocos from 10 deals so far this year, compared with $9bn for five deals during all of 2012 according to Dealogic, the data provider.
Mr Podobnik said he expected about €30bn of tier one coco issuance in 2014.
Sandeep Agarwal, head of European debt capital markets at Credit Suisse, said regulatory changes under the EU’s CRD IV proposal next year will cement cocos’ status as a capital buffer.
“There will be a significant step jump in issuance next year,” he said. “Regulatory clarity means banks will embark on building up their tier one and tier two capital bases [and] we estimate about $75bn-$100bn in issuance for 2014.”
The CRD IV proposal deals with the implementation of the Basel III banking changes in Europe.
Cocos’ evolution has not been without controversy, with some investors criticising them for being overly punitive to creditors. For example, “sudden death” cocos could enable a bank to write down the value of the bond while the bank remains a going concern or continues to pay dividends to equity holders.
Despite that, record low interest rates have bolstered demand among yield-starved investors as more cocos have come to market.
“The investor base has broadened this year . . . at the beginning it was mostly Asian private banks, now it’s more institutions,” said Mr Podobnik.
Earlier this month Barclays, one of the most prolific coco issuers, launched its third deal in the past 12 months. All Barclays’ cocos were issued with coupons yielding between 7.6 per cent and 8.25 per cent, which is higher than the interest yield on most Barclays debt.
All but one coco deal to date have been issued in Europe against a wider backdrop of deleveraging by eurozone banks, one consequence of which is the lowest issuance of senior unsecured debt – a traditional mainstay of banks’ funding – in a decade.