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Determinants of the Interest Rate Premium on Contingent Convertible Bonds (CoCos)

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Abstract

Ruling out default prior to conversion of high-trigger (going-concern) CoCos, this paper concentrates on estimating the conversion risk premium on CoCos. It does so by estimating the cost of hedging that risk with a contingent put option, exercisable only in the event of conversion, whose strike price is set at the conversion price per share (CPS). In this situation, the level of the common equity tier-1 (CET1) capital ratio at the time that the CoCos are issued plays a central role: it determines the probability of conversion during the term of the CoCos and the level of the CPS, relative to the market price per share (MPS) at the time of CoCos issuance, that must be set to stabilize the expected replacement rate, here at 80%. This replacement rate implies that CoCos holders can expect to lose 20% of the face value of CoCos in the event of conversion and are moved to exercise debt discipline. At the same time, existing shareholders derive sufficient comfort from conversion, for the losses leading up to it, not to oppose the issuance of CoCos in the first place. If the issuing companies have initial Basel III-based capital ratios that are at least 3 percentage points above the 7% going-concern trigger, covering the conversion risk should cost only a third as much as the average premium now required on equity into which, upon conversion, the CoCos would turn. By issuing such CoCos, banks can thus equip themselves with a form of contingent equity line. That line is activated automatically when triggered by adversity to rebuild their capital at a bargain without causing dilution for existing shareholders.

Suggested Citation

  • von Furstenberg, George, 2013. "Determinants of the Interest Rate Premium on Contingent Convertible Bonds (CoCos)," Journal of Financial Perspectives, EY Global FS Institute, vol. 1(2), pages 133-144.
    • Handle: RePEc:ris:jofipe:0022
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    Cited by:

    1. Philippe Oster, 2020. "Contingent Convertible bond literature review: making everything and nothing possible?," Journal of Banking Regulation, Palgrave Macmillan, vol. 21(4), pages 343-381, December.

    More about this item

    Keywords

    Contingent convertible debt securities; CoCos; Basel III; Capital requirements;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation

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