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

17 Pages Posted: 27 Nov 2017

Date Written: July 24, 2013

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 M., Determinants of the Interest Rate Premium on Contingent Convertible Bonds (CoCos) (July 24, 2013). Journal of Financial Perspectives, Vol. 1, No. 2, 2013. Available at SSRN: https://ssrn.com/abstract=3076954

George M. Von Furstenberg (Contact Author)

Indiana University ( email )

Department of Economics
Wylie Hall, Indiana University
Bloomington, IN 47405-6620
United States
812-856-1382 (Phone)
812-855-3736 (Fax)

HOME PAGE: http://mypage.iu.edu/~vonfurst/

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