A Practical Insight Into the World of Coco Bonds: An Empirical Analysis of what CoCo Bonds Are, and why We Should Care About Conversion Risk

Anders Jakobsen & Lasse Christian Krull Pedersen

Student thesis: Master thesis

Abstract

Contingent Convertible Bonds have over recent years been labeled as the “New kid of derivatives” or even worse “High-yield investment with a hand grenade attached”. The purpose of this thesis is to shed light on what Contingent Convertible bonds exactly are, what purpose do they fulfill and what sort of risk are embedded into these hybrid bonds?
To give an introduction to what CoCo bonds is, this thesis dives into the financial regulation, directed by the Basel III legislation. A qualitative analysis will be undertaken to show how CoCo bonds have become a flexible way for banks to obtain new funding.
There are many different academically developed pricing methods for the pricing of CoCo bonds. Because there is no universally accepted pricing method employed in the market, the most optimal way of pricing a CoCo bonds is still a heavily debated topic. In this thesis, a quantitative binomial framework is employed to capture the conversion risk, modeling the CET1 ratio of Barclays using three different models. This thesis finally examines what other factors can explain the historical movements in the yield spreads of CoCo bonds as this potentially could put some light on the mechanics of conversion risk. The analysis will be conducted through quantitative statistical regression analyses.
The results of the investigation of what shows that to banks, CoCo bonds can be a relatively cheap way of obtaining new capital as interest payments usually are tax deductible. Further, the loss-absorbing feature embedded in the trigger mechanism can ensure that banks can remain going concern in times of financial distress. Furthermore, along with the conversion, which can significantly diminish the value of the investment, investors should further be aware of the interest payments, which the issuer at any point in time, can choose to cancel.
The pure binomial setup results in an outlook for the Barclays CoCo bond with little to no conversion risk. The other two developed models both provide a higher weighted probability of conversion risk, but unfortunately, also overestimate the price of the CoCo bond compared to the price in the market.
The factors examined in regression analysis, resulted in the following; CDS spread is the only explanatory variable, which shows a consistent significant correlation towards the yield spread in the multiple regressions. Thus, the equity prices which is a proxy for the pure conversion risk seems to have little to no direct effect on the pricing of the CoCo bonds, as neither the VIX shows coefficients have consistent significance towards the yield spread.

EducationsMSc in Finance and Investments, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2016
Number of pages128