Credit Suisse CoCo oversubscription dispels concerns over investor demand

Early scepticism over the appeal of contingent convertible instruments appears to be fading as Credit Suisse CoCo issue attracts significant demand.

August 2010 saw the Basel Committee on Banking Supervision unveil proposals on loss-absorbing regulatory capital instruments that could either be written down or converted to equity on the hitting of a predetermined trigger.

But some investors questioned the broader appetite for these contingent convertible instruments, or CoCos. Concerns were raised about the trigger points of such deals, with questions over whether an accurate common equity tier 1 ratio could be calculated for the conversion point. An additional potential stumbling block seemed to arise from the Basel Committee’s suggestion that the decision on whether a trigger point had been breached should be left to national regulators to determine.

The Swiss Financial Markets Authority (Finma), the country’s financial regulator, was especially keen to introduce CoCos. In October the regulator recommended that the country’s two biggest banks, Credit Suisse and UBS, should each hold 9% of capital in the form of CoCos or similar assets. This is in addition to an earlier recommendation that they should hold 10% of capital in the form of common equity.

Responding to these regulations, Credit Suisse worked with Finma to sculpt its CoCo programme. It was decided that of the 9% of additional capital coming through CoCos, 6% would be through the sale of low trigger securities (converted when the tier 1 ratio falls below 5%), and 3% through the sale of high trigger securities (converted when the tier 1 capital falls below 7%).

The first stage in this process was completed on February 14. Credit Suisse announced it would exchange CHF6 billion of tier 1 instruments issued in 2008 for new high trigger tier 1 CoCos, called buffer capital notes, to two strategic investors: Qatar Holding, a subsidiary of the country’s sovereign wealth fund, and Olayan Group, a Saudi-based investment fund.

The securities can be exchanged no earlier than October 2013. The $3.5 billion dollar BCNs will carry a coupon of 9.5%, while the CHF2.5 billion notes carry a coupon of 9%.

Of more significance in the context of whether there will be deep investor interest for CoCos, Credit Suisse followed the exchange on February 17 with a public sale of $2 billion of tier 2 BCNs. The securities, rated BBB by Fitch, have a 30-year final maturity, but can be called at any time from August 2016. Through the exchange offer and public sale, Credit Suisse has issued over 70% of the high trigger instruments required by Finma.

The BCNs will be converted to Credit Suisse ordinary shares if the bank’s reported consolidated risk-based capital ratio falls below 7%. However, they could also be converted if Finma determines that Credit Suisse requires financial support to keep it as a going concern.

Yet if there were any concerns about CoCos from investors, at least as far as this borrower was concerned, they were overwhelmed by the positive investor reaction to the transaction. More than 500 investors placed orders totalling €22 billion, an 11 times oversubscription.

“It was a phenomenal success to get north of €20 billion of orders for a new product,” says Chris Tuffey, co-head of credit capital markets at Credit Suisse.

There was also strong support for the securities in the secondary market, with the issue yield of 7.875% on the bonds compressing to 7.35% by the close on February 24.

Equity conversion

Prior to the sale, questions were asked over whether investors would be happy to take on the risk of an equity conversion rather than simply suffer a haircut. One reason for strong investor appetite was the security of the issuer: Credit Suisse is viewed as a bank with a strong balance sheet and brand recognition, making a trigger event unlikely.

Under the new proposals, the trigger for tier 2 investors would at least not be activated until after its tier 1 investors had already seen their debt converted to equity. That would give Credit Suisse time to rebalance its books to avoid conversions further up the capital structure.

Additionally, Credit Suisse would be obliged to take strong measures as soon as its common equity ratio fell below 10%, which again would lessen the likelihood of a tier 2 conversion ever taking place. For Credit Suisse, the exchange deal with Qatar Holdings and Olayan Group added a layer of structural protection to the tier 2 instruments.

“Credit Suisse has the security of its strategic investors,” says Christian Evans, founding partner and portfolio manager at London-based hedge fund PVE Capital. “I think announcing that the Qataris are going to engage in this transaction provided a great backdrop for Credit Suisse to go out and appeal to other investors.”

Christophe Akel, who runs a long-only investment grade fund at hedge fund manager GLG Partners, also views the strategic investor allocation as crucial.

“It is important to understand how [the bank’s] management would react if the trigger point was reached,” he says. “Allocating big chunks of these bonds to its own clients means it would not be in the bank’s interests to treat bondholders poorly, which is obviously reassuring.”

The nature of such instruments provides a further level of assurance since, even if a trigger event took place, there is still the potential for some upside should the bank (and its share price) recover.

“A number of investors said they were uncomfortable with taking on instruments that would be permanently written off,” says Tuffey at Credit Suisse. “We wanted to find a way to rebuild the capital of the firm that allowed investors to participate in the recovery.”

For investors whose mandate allows them to hold equity, that would be a far more attractive prospect than taking an automatic haircut; which is the option that Dutch bank Rabobank decided on with its own sale of CoCos.

“The good news is that the bond converts to equity and it is not just a write-off. At least there is the chance that you might have something left over,” says Georg Grodzki, head of credit research at Legal & General Investment Management in London.

There was more interest in the distribution of the instruments than usual, with many questioning who they would actually be targeted at. Prior to the sale, it was argued that equity accounts might find the lack of upside call options unappealing, while fixed income buyers might view the instruments as falling outside their portfolio mandates.

The level of oversubscription suggests Credit Suisse found the answers to these questions, although not all investors could participate.

“It just doesn’t comply with the spirit and the wording of the mandates we are actually using when we are managing other people’s money,” says an investor at a London-based asset manager, who spoke on condition of anonymity. “And if it does lie in your area, what happens if the trigger is reached? Some fixed income funds cannot hold equity and will have to sell at the worst time – just as they convert. That does not bode well when it comes to getting your money back.”

Nevertheless, the bank says almost all the bonds placed with fixed income investors.

“It was very heavily allocated to fixed income buyers, and some large global funds that have convertibles in their portfolios. There was also some limited appetite from equity,” says Credit Suisse’s Tuffey.

Setting a precedent

The question now becomes whether Credit Suisse will prove to be trailblazers in this field, providing a strong model for other banks to follow. Tuffey says other banks may go through a period of trial and error when it comes to deal structures.

“The trade was different from the existing Rabobank deals in the market, and I think there will be a variety of CoCo structures to come,” says Tuffey.

In January, Rabobank placed €2 billion of hybrid tier 1 securities, with the bonds subject to a permanent writedown when the bank’s consolidated equity capital ratio falls below 8%. The level of debt written down would be restricted to the amount required to increase the capital ratio back above 8%.

Evans believes that future deal structures will have to adopt a flexible approach that takes into account the particular financial characteristics of each issuer. Credit Suisse and Rabobank achieved success because investors viewed it as being extremely unlikely they would breach the triggers on their deals. Other issuers might be considered a riskier proposition, however, and would likely have to pay a much higher premium. 

“Credit Suisse has provided a kind of blueprint for where contingent capital can be issued, but I think there has to be more balance sheet analysis,” says Evans.

Deal terms
Issuer: Credit Suisse
Size: $2 billion
Issue date: February 17, 2011
Maturity: February 24, 2041
Call date: Callable at par on August 24, 2016
Ratings: BBB+ (Fitch)
Coupon: 7.875%
Issue price: 100
Bookrunner: Credit Suisse