CoCos: View from the buy-side
With standardisation of contingent capital structures such as Crédit Agricole’s AT1 still some way off, pricing the new instruments is by no means easy. Here, Michel Baud, portfolio manager at BNP Paribas AM, shares his view on Crédit Agricole’s transaction and explores how investors can value the new structures being developed.
Michel Baud, BNP Paribas AM
By the time the new Crédit Agricole AT1 was issued, there had already been a number of AT1 CoCos from various European banks during the end of 2013, including deals from Société Générale, Barclays, Credit Suisse and even some Spanish banks.
This new issue was an opportunity to get an attractive yield (close to 8%) on the issuer, far above the existing “old-style” Tier 1 (at best 4.7% yield to call, or 6.1% yield to maturity for the existing Tier 1 callable in 2019), and also above the existing Lower Tier 2 CoCo high trigger issued in September (5.4% yield to call, or 7% yield to maturity).
CoCos are complex instruments that require more detailed analysis than standard bonds. In addition to the classic fundamental credit analysis of the issuer, it is key to review the structure of the bond, since each instrument has its own features. This consists of analysing:
- The risk of hitting the trigger, which depends on the solvency of the bank and its risk profile;
- The risk of reaching a “point of non-viability” — where the regulator takes control of the bank;
- The risk of non-payment of coupons — for AT1 CoCos, coupons are discretionary, but cancellation could become mandatory below a certain level of solvency;
- The jurisdiction risk;
- The risk of modification of the prospectus, under tax or regulatory events;
- And any other specific element.
As far as the trigger is concerned, the new Crédit Agricole AT1 was different from the existing securities: while AT1s are usually classified as “low” or “high” trigger, this new bond came with a “dual trigger” structure — a capital ratio event could occur if a low trigger is reached at the issuing entity (CASA), or a high trigger is reached at the group level.
Unlike for other banks, we understood this constraint was included because of the regulator, given the specific structure of the Crédit Agricole entities.
This dual trigger structure adds complexity to the perceived risk and the pricing of the structure. In theory, the dual trigger increases the probability to breach the ratios.
However, this should be put in perspective.
First, the level of capital is far more comfortable at the group level than in CASA, so under a worst case scenario, the most likely scenario is the latter being hit before the former.
In addition, the intra-group guarantees are expected to work before, contributing positively to the distance to trigger at CASA level.
Based on third quarter 2013 figures, the current distance to trigger at CASA is 4.275 percentage points (9.4 vs 5.125) and at the group level 4.6 percentage points (11.6 vs 7), but the projected amount is lower.
Indeed, the transition into Basel III further adds to the complexity, as a lower 7.8%-8% Basel III ratio is expected as of 1 January 2014 (mainly due to the impact on RWA). As a result, the adjusted distance to trigger (Basel III phase-in) is currently only 1.3 percentage points, before increasing back to reach 2 percentage points at year-end (based on the issuer’s projections).
The loss absorption language of the new Crédit Agricole AT1 is more investor friendly than some other CoCos, which have a permanent full write-down.
In the case of Crédit Agricole’s AT1, under a breach of one of the capital ratios a loss absorption would occur in the form of a partial and temporary write-down of principal. In the event of a return to financial health, a gradual write-up could occur under certain conditions (a positive consolidated net income is recorded, subject to minimum distributable amount), at the issuer’s sole discretion.
Coupon risk is an additional important part of the risk on AT1 instruments, which can be measured by the distance to coupon restriction (7% ratio on CASA, based on 4.5% minimum CET1 ratio plus capital conservation buffer). This distance will decrease to 2.5 percentage points as of 2019 (but will keep being more than 4 percentage points until 2016 in the transitional regime). The constraints at the group level are less stringent than for CASA: at the group level the distance to coupon restriction level (8.5% including the additional systemic buffer) will decrease to 4.5 percentage points in 2019, but will remain above 7.5 percentage points until 2016.
Quantifying each of the risks listed above and pricing accordingly such a security is not easy. As CoCos are complicated securities with embedded options, it is complex to tackle their valuations in a straightforward way. There is no standardised pricing methodology that is unanimously recognised. Nevertheless, the following approaches could be used.
As a starting point, a basic approach based on relative value could be applied: as there is a nascent market of CoCos (especially in US dollars), existing CoCos are compared to other bonds.
In order to better quantify the loss absorption mechanisms of those instruments, some more advanced pricing methodologies are required, the more efficient adopting either a credit derivatives approach or an equity derivatives approach.
Only a few market participants have developed such “in-house” tools so far.
For this new issue, the best comparable was the Société Générale AT1 (which has almost the same call date, and similar absorption language), trading with 7.4% yield to call, or a 7.1% yield to maturity. However, this security does not have dual trigger characteristics, having a single low trigger (at 5.125%).
For Société Générale, the distance to trigger is 4.775 percentage points (9.9% Basel III vs 5.125%) — i.e. more than Crédit Agricole — while the distance to coupon restriction will decrease to 1.9 percentage points in 2019, i.e. less than Crédit Agricole (but will stay above 4.5 until 2016). These items could only be quantified by using advanced pricing methodologies (as mentioned above).
Despite the limitations some investors can face on such securities — such as low or no ratings, exclusion from benchmarks, regulatory capital treatment, etc — this new issue was particularly well received by the market. Total orders were more than $25bn for a deal size of $1.75bn.
Initially announced in a range of 8.125%-8.375%, the final yield was 7.875%, equivalent to a spread of 489bp, and the following day the price was almost 3 points higher.
While initial CoCos were placed mainly through Asian private banking networks, asset managers made up more than 60% of Crédit Agricole’s book. However, continental Europe is still reluctant to invest in such product (with half of the demand having come from the US and Canada, and 22% from the UK), which still leaves good potential for the development of this asset class going forward.
For more on Crédit Agricole’s AT1 transaction, read: