SNAP ANALYSIS-Swiss give fresh momentum to contingent bonds

October 4, 2010

RTXSLHY_CompBy Jane Merriman

LONDON, Oct 4 (Reuters) – Contingent capital got a boost on Monday as Swiss regulators said these bonds, which convert to equity when banks are in trouble, could help bolster the capital base of Credit Suisse and UBS.

The Swiss initiative marks a step forward for the asset class, which has failed to find a big fan base among investors since UK bank Lloyds and Dutch-based Rabobank issued contingent-style bonds in November 2009 and March this year.

International financial regulators have looked at what role these bonds, known as “CoCos”, could play in the new Basel III capital regime for banks, particularly for those lenders deemed too big to fail.

“What the market was waiting for was clarity on the regulatory treatment of CoCos and for the Swiss banks this (regulatory ruling) does that,” said Daniel Bell, director of product development at Bank of America Merrill Lynch.

Also, in the current low-yield environment which looks set to persist given potential moves towards more quantitative easing by central banks, investors’ appetite for higher-yielding assets could work in contingent capital’s favour.

CoCos are bonds that convert into equity under certain conditions, usually when a bank’s store of capital falls below a certain trigger point.


“It’s the first announcement we’ve seen that partly clarifies one of the unknowns of Basel III — what is the higher capital requirement for systemically important financial institutions,” said Oliver Judd, credit analyst at Aviva Investors.

“The Swiss are the first to say what this might look like and the CoCos might fill that gap.”

But the Swiss move does not answer all questions.

“It is a development which could establish more issuance. But there is no detail on what these instruments need to look like, nor does the Swiss plan explain what investors would be buying,” Judd said.

Another big roadblock has been rating agencies’ reluctance to rate CoCos because of a lack of clarity from regulators surrounding the conversion trigger.

Lloyds used them to augment a capital raising last year when it was scrambling to avoid a costly government insurance scheme for bad debts. But when Rabobank issued contingent senior bonds as a cost-effective way to gain access to equity capital in future, the rating agencies shunned them.

“We would buy,” said Ed Devlin, a fund manager at PIMCO. “But it depends very much on the institution and the structure … There is not a homogenous market and the devil is in the detail on these instruments.

“Ratings are beneficial not because we rely on them, but often in guidelines our clients give us,” Devlin said. “We have to have ratings. It’s the same for most institutional and retail money managers.”

Under the Swiss plan, Credit Suisse and UBS would be required to hold at least 10 percent common equity, plus another 9 percent in the form of CoCos, which would convert to equity under certain conditions.

Three percent in CoCo bonds would be triggered if common equity fell below 7 percent and the other 6 percent of capital in the form of CoCo bonds would be triggered if common equity fell below 5 percent.

“I think a market could emerge if the products were generally very attractively priced by the issuers,” said UBS Chief Financial Officer John Cryan in a call with analysts.

“The market has to decide who’s the natural buyer … whether it’s fixed income investors or whether it’s specialist situation investors or whether it’s equity investors,” he said.

“It’s not that I am a nay-sayer, it’s just that there is no market for the volumes. You are looking at an immensely deep market for something that is quite an obscure and untested instrument.”

(Additional reporting by Alex Chambers in London and Sven Egenter in Zurich; Editing by David Holmes) ((; +44 207 542 3121; Reuters

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