Multiple Trigger CoCos: Contingent Debt Without Death Spiral Risk

Abstract

This paper starts with the observation that the average issue size during 2012 of contingent convertible (CoCo) bonds was more than $1 bn. Typically a CoCo is converted into shares when a pre-defined capital ratio such as the core tier 1 ratio (CT1) drops below a minimum level. In some other cases, the contingent convertibles investors will suffer from a predefined haircut instead of a conversion into shares. Investors could dynamically hedge the equity exposure embedded within a contingent convertible by taking an offsetting short position in the underlying shares. This dynamic hedging can in some circumstances have a negative impact on the share price of the bank. It could indeed lead to a spiral of falling share prices. This so-called death spiral effect can only be avoided if the size of the contingent convertible is moderate compared to the amount of outstanding public traded shares. In this contribution we advocate the use of contingent debt where there is more than one conversion trigger. Banks should move away from one large single CoCo issue towards issues with multiple accounting triggers spread across an extended range. This will alleviate the death spiral risk. The expected dynamic behavior of a CoCo bond has been modeled using a credit derivates approach. From these models we then quantify the equity sensitivity and the negative gamma resulting from the design of a contingent convertible and illustrate the possible pitfalls of a death spiral on the share price.

The Impact of a New CoCo Issuance on the Price Performance of Outstanding CoCos

“…In De Spiegeleer et al [10] the implied CET1 volatility is derived from the market price of a CoCo bond. Further extensions and variations can be found in De Spiegeleer and Schoutens [11,12], Corcuera et al [13], De Spiegeleer and Schoutens [14], Cheridito and Zhikai [15], Madan and Schoutens [16].…”

How do capital structure and economic regime affect fair prices of bank’s equity and liabilities?

“…Table 5 shows the average of 12 months Libor rates, observed in each economic regime. It also presents the vector ξ dening the risk neutral measure Q, which is the solution of the system of equations (15). The drifts of X t under the risk neutral measure Q are obtained from relationship (10).…”

Hybrid Securities

“…In times of distress, CoCo investors may dynamically hedge the equity exposure embedded within a CoCo by taking an offsetting short position in the underlying shares (De Spiegeleer and Schoutens, 2013). This would unleash a self-fulfilling death spiral, accelerating the downward trajectory of a bank's shares during a crisis (International Financial Law Review, 2014).…”