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Perpetual Bonds as AT1 capital?


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Hi, @David Harper CFA FRM

I am wondering if the Perpetual Bonds can be used as AT1 capital and wanna know if there are any cases study that can be find in the US/EUROPE Banking industry that use the Perpetual Bonds as AT1.

I also noticed that there is a CoCo Bond relevant LOS. Can I interpret the Perpetual Bonds as an example of CoCo Bonds?

Thanks for helping.

David Harper CFA FRM

David Harper CFA FRM
Staff member
Hi @valenski I'm not really certain/up-to-date about perpetual bonds vis-a-vis AT1; my naive interpretation is that they would generally qualify, see criteria (55.) for inclusion on page 15-16 in bcbs189 here at https://www.bis.org/publ/bcbs189.htm ie., (emphasis mine)
Criteria for inclusion in Additional Tier 1 capital
  1. Issued and paid-in
  2. Subordinated to depositors, general creditors and subordinated debt of the bank
  3. Is neither secured nor covered by a guarantee of the issuer or related entity or other arrangement that legally or economically enhances the seniority of the claim vis-à-vis bank creditors
  4. Is perpetual, ie there is no maturity date and there are no step-ups or other incentives to redeem
  5. May be callable at the initiative of the issuer only after a minimum of five years: a. To exercise a call option a bank must receive prior supervisory approval; and b. A bank must not do anything which creates an expectation that the call will be exercised; and c. Banks must not exercise a call unless: i. They replace the called instrument with capital of the same or better quality and the replacement of this capital is done at conditions which are sustainable for the income capacity of the bank15; or ii. The bank demonstrates that its capital position is well above the minimum capital requirements after the call option is exercised.
  6. Any repayment of principal (eg through repurchase or redemption) must be with prior supervisory approval and banks should not assume or create market expectations that supervisory approval will be given
  7. Dividend/coupon discretion: a. the bank must have full discretion at all times to cancel distributions/payments b. cancellation of discretionary payments must not be an event of default c. banks must have full access to cancelled payments to meet obligations as they fall due d. cancellation of distributions/payments must not impose restrictions on the bank except in relation to distributions to common stockholders.
  8. Dividends/coupons must be paid out of distributable items
  9. The instrument cannot have a credit sensitive dividend feature, that is a dividend/coupon that is reset periodically based in whole or in part on the banking organisation’s credit standing.
  10. The instrument cannot contribute to liabilities exceeding assets if such a balance sheet test forms part of national insolvency law
  11. Instruments classified as liabilities for accounting purposes must have principal loss absorption through either (i) conversion to common shares at an objective pre-specified trigger point or (ii) a write-down mechanism which allocates losses to the instrument at a pre-specified trigger point. The write-down will have the following effects: a. Reduce the claim of the instrument in liquidation b. Reduce the amount re-paid when a call is exercised; and c. Partially or fully reduce coupon/dividend payments on the instrument.
  12. Neither the bank nor a related party over which the bank exercises control or significant influence can have purchased the instrument, nor can the bank directly or indirectly have funded the purchase of the instrument
  13. The instrument cannot have any features that hinder recapitalisation, such as provisions that require the issuer to compensate investors if a new instrument is issued at a lower price during a specified time frame
  14. If the instrument is not issued out of an operating entity or the holding company in the consolidated group (eg a special purpose vehicle – “SPV”), proceeds must be immediately available without limitation to an operating entity or the holding company in the consolidated group in a form which meets or exceeds all of the other criteria for inclusion in Additional Tier 1 capital
CoCo bonds are in the syllabus under Hull's RM&FI Chapter 16 ("Describe the mechanics of contingent convertible bonds (CoCos) and explain the motivations for banks toissue them.") which is a reference to the following.

16.3 Contingent Convertible Bonds
An interesting development in the capitalization of banks has been what are known as contingent convertible bonds (CoCos). Traditionally, convertible bonds have been bonds issued by a company where, in certain circumstances, the holder can choose to convert them into equity at a predetermined exchange ratio. Typically the bond holder chooses to convert when the company is doing well and the stock price is high. CoCos are different in that they automatically get converted into equity when certain conditions are satisfied. Typically, these conditions are satisfied when the company is experiencing financial difficulties.

CoCos are attractive to banks because in normal times the bonds are debt and allow the bank to report a relatively high return on equity. When the bank experiences financial difficulties and incurs losses, the bonds are converted into equity and the bank is able to continue to maintain an equity cushion and avoid insolvency. From the point of view of regulators, CoCos are potentially attractive because they avoid the need for a bailout. Indeed, the conversion of CoCos is sometimes referred to as a “bail-in.” New equity for the financial institution is provided from within by private-sector bondholders rather than from outside by the public sector.

A key issue in the design of CoCos is the specification of the trigger that forces conversion and the way that the exchange ratio (number of shares received in exchange for one bond) is set. A popular trigger in the bonds issued so far is the ratio of Tier 1 equity capital to risk-weighted assets. Another possible trigger is the ratio of the market value of equity to book value of assets.

Lloyd's Banking Group, Rabobank Nederlands, and Credit Suisse were among the first banks to issue CoCos. Business Snapshot 16.1 provides a description of the bonds issued by Credit Suisse in 2011. These bonds get converted into equity if either Tier 1 equity capital falls below 7% of risk-weighted assets or the Swiss bank regulators determine that the bank requires public-sector support. It has been estimated that over $ 1 trillion of CoCos will be issued by banks during the decade beginning 2010 as they respond to the new Basel III regulatory requirements on capital adequacy.

CoCos (prior to conversion) qualify as additional Tier 1 capital if the trigger, defined in terms of the ratio of Tier 1 equity capital to risk-weighted assets, is set at 5.125% or higher. Otherwise they qualify as Tier 2 capital.

BUSINESS SNAPSHOT 16.1: Credit Suisse's CoCo Bond Issues
On February 14, 2011, Credit Suisse announced that it had agreed to exchange $ 6.2 billion of existing investments by two Middle Eastern investors, Qatar Holding LLC and the Olayan Group LLC, for CoCo bonds. The bonds automatically convert into equity if either of the following two conditions are satisfied:
  1. The Tier 1 equity capital of Credit Suisse falls below 7% of risk-weighted assets.
  2. The Swiss bank regulator determines that Credit Suisse requires public-sector support to prevent it from becoming insolvent.
Credit Suisse followed this announcement on February 17, 2011, with a public issue of $ 2 billion of CoCos. These securities have similar terms to ones held to the Middle Eastern investors and were rated BBB + by Fitch. They mature in 2041 and can be called any time after August 2015. The coupon is 7.875%. Any concerns that the market had no appetite for CoCos were alleviated by this issue. It was 11 times oversubscribed.

Credit Suisse indicated that it plans to satisfy one-third of the non-equity capital requirement with bonds similar to those just described and two-thirds of the non-equity capital requirement with bonds where the conversion trigger is about 5% (rather than 7%) of risk-weighted assets." -- Hull, John C.. Risk Management and Financial Institutions (Wiley Finance) (Kindle Locations 12959-12965). Wiley. Kindle Edition.
As to whether CoCos are necessarily perpetual, I found this: CoCo's: a primer (BIS, 2013) https://www.bis.org/publ/qtrpdf/r_qt1309f.pdf
Regulatory capital eligibility considerations are a major factor not only in the selection of CoCo triggers, but also in the choice of their original maturity. In the Basel III framework, all AT1 instruments must be perpetual. That explains why over a third of all CoCos issued so far have no maturity date. The rest of the existing CoCos are dated and are therefore only eligible to obtain T2 capital status under Basel III. Most of them have an original maturity of approximately 10 years.
Re cases, I have noticed that the FT tends to discuss them not infrequently; e.g., How Santander kept a $200bn bond market guessing https://www.ft.com/content/fab7083c-2eef-11e9-ba00-0251022932c8
"... While the furore may perplex outside observers, it was a watershed in the $200bn market for “additional tier 1” (AT1) or “coco” bonds, the riskiest type of bank debt that can be written off in times of stress. The European market has long relied on an understanding that banks will repay their bonds at the first opportunity. A rare decision by Deutsche Bank not to call such a bond a decade ago sent tremors through the market at the height of the financial crisis. "

I hope that's some help, thanks,
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