CoCo Bonds with Extension Risk
33 Pages Posted: 5 Feb 2014
Date Written: February 3, 2014
This article provides an in-depth analysis of the pricing and structuring of contingent convertibles (CoCos) with extension risk. Under the new regulatory Basel III framework, CoCo bonds can be categorised as either belonging to the Additional Tier 1 or Tier 2 capital category. The Tier 1 CoCo bonds have cancellable coupons and do not have a predefined maturity. In addition, they contain no incentive, such as a coupon step-up, for the issuer to redeem at the first call date. This is in sharp contrast with the old-style hybrid bonds issued by financial institution before the 2008 financial crisis. At that time, banks issued callable bonds with a coupon-step up after the first call date. These bonds were categorised as additional Tier 1 and their step-up feature reduced the probability that the bank skipped the call and kept the bond alive. The existence of the coupon step up was considered by a lot of practitioners as a justification to categorise those bonds as fixed maturity bonds that expire on the first call date. The fact that coupon step-ups are no longer allowed in the new regulatory framework, forces us to think differently when dealing with Tier 1 bonds. We explain how to integrate this extension risk into a valuation method for CoCo bonds.
Keywords: contingent capital, CoCo bonds, extension risk, bail-in, additional Tier 1, Tier 2
JEL Classification: G12, G13, G18, G21, G28, G32
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