Investors often hail contingent convertibles as the best form of new style hybrid capital, saying they align the interests of management, shareholders and creditors. In contrast, debt holders worry that instruments that take a principal write-down — whether temporary or permanent — in times of stress would unfairly hit creditors over equity holders.
But their attitudes towards Cocos are always coloured by the floor price on any potential conversion. Issuers include floor prices to protect shareholders against dilution. But bondholders reason that if a bank is stressed, its shares are likely to slump. And if a conversion price is floored at, say, €5, but the bank’s shares are trading at €1 upon conversion, bondholders would take a mighty haircut.
Credit Suisse attracted questions earlier this month when it launched a Swiss franc buffer capital note with a floor price that was just a few francs below where the shares were trading at the time. The concern did not impede the deal — the bank was still able to sell Sfr700m of the stuff to yield hungry domestic investors. But it is something issuers need to bear in mind when bank tier one issuance restarts in earnest once the market has greater regulatory clarity.
Swiss Re responded to these worries last week with its perpetual, non-call 6.5 year capital trade. The insurer can convert the bond to equity at any point. But crucially, such conversion would have no floor price. Rather, the price would be determined by applying a 3% discount to the volume weighted average price of the shares over the past five days — so a slight discount to market rates.
Insurance capital is a very different beast to bank capital. But lenders should take note nevertheless. Many argue that such conversion pricing structures align the interests of all parties better than any others, leading to a system that is more stable than banks capitalised with other forms of loss-absorbing hybrid capital. If a bank really does believe it has — to use the marketing buzzwords — a "fortress balance sheet", then it shouldn't be afraid to copy a structure that insurers have made their own.