Hybrid bonds were initially conceived as debt instruments with equity-like features, and their legal characteristics are similar to those of convertible preference shares. Issuance of such bonds has accelerated since the financial sector meltdown in 2008. Contingent convertible bonds (CoCos) constitute a sub-category within the overall grouping of hybrid bonds. The CoCo acronym seems to have developed after Lloyds Banking Group successfully converted more than $10 billion of its hybrid bonds to CoCos in December 2009. This article examines the risk features of hybrid bonds and CoCos and whether the substantial risk inherent in them is masked from investors.
According to The Economist, European companies have issued hybrid bonds amounting to $32 billion in 2013 ("Hybrid Corporate Bonds - The Rating Game", November 2, 2013). However, the issuance volumes and stocks of hybrid and CoCo offerings are relatively small compared with plain-vanilla bonds. For instance, annual bond issuance in the United States amounted to about $5 trillion in 2012. And the total stock of US bonds alone at the end of 2012 was $38.1 trillion. The major components are: Treasury bonds and bills, $10.9 trillion; corporate bonds, $9.1 trillion; and mortgage-related securities, $8.6 trillion (source: the Securities Industry and Financial Markets Association). Consequently, it is likely that hybrids and CoCos will not pose a systemic risk - as yet.
Hybrids, and more specifically CoCos, are designed to enable issuers to remain solvent even when they are not in a position to service their bonds. These bonds convert partly or wholly to equity when pre-agreed stress levels are breached for the bond issuer. In other words, bondholders end up owning equity in the bond issuer institution when the latter faces liquidity or solvency problems. The countervailing compensation for bondholders is higher rates of interest for having sold bond issuers the option to convert debt into equity in times of financial/economic stress.
Effectively, for issuing institutions, such bonds are contingent capital. Investors do receive a higher rate of return than that for standard bonds, which is expected to compensate them for having sold options to the debtor. The higher interest payments, which the debtor institution has to make, can be present valued at market rates of interest. Adjusted for risk, this is the additional capital that debtor institutions should be required to hold when they issue hybrid bonds. As of now, regulators are not asking for a commensurate amount of extra capital to be held. In fact, CoCos seem to serve as a pretext to hold less risk capital, since these are perceived as risk-reducing instruments for issuers. However, the embedded options are a way of holding less than the required amount of capital. Investors can be misled into underestimating the full value of the embedded options and, thus, induced to accept a lower rate of return. Unfortunately, some institutional investors are open to being misled, since compensation packages for investment managers are often based on achieving ambitious investment volumes within tight time deadlines.
To rephrase simplistically, who in their right minds would invest in the equity of an institution precisely when that firm is facing liquidity or solvency issues? By contrast, banks and corporate issuers have every incentive to sell underpriced options concealed within hybrid bonds to unsuspecting or complicit investors. Such hybrid bonds can be crafted to reduce risk for issuers at the expense of investors and marketed as innovative financial products.
An inescapable fact is that embedded options in hybrids or CoCos cannot be valued accurately. There are no databases that provide reliable probabilities of trigger events for individual issuers. That is, there is no way anyone can arrive at the underlying volatilities to plug into an option pricing or the Monte Carlo simulation model to value options embedded in hybrid bonds with acceptable precision.
It appears that national capital-market regulators have not focused on accurate valuation of the embedded options in hybrids. Such scrutiny is likely to be resisted by banks and financial institutions promoting these bonds. Their logic probably is that any attempt to value the options fairly - that is, more expensively - amounts to being anti-innovation. Regulators, too, do not have much incentive to investigate the valuations carefully, because they usually have limited in-house technical capabilities and also since their remit is to limit risk to institutions rather than to dispersed investors. Further, such risks for investors may be of little concern even to the media since the assumption is that if large numbers of individual investors are adversely affected, governments will necessarily come to their rescue. It is worrisome, therefore, that multilateral bodies such as the Financial Stability Board or the Basel Committee for Banking Supervision have not examined hybrid bonds more thoroughly (as is evident from the lack of quantitative analysis of embedded options in these bonds on their websites).
It may be possible to shield retail investors from losses on CoCo bonds by making such securities marketable only to hedge funds. This should prevent hybrids and CoCos from becoming one of the causal factors driving future government bailouts. Of course, hybrids constitute a small component of bond markets; and precautions such as adequate risk capital, transparent mark-to-market practices, and the provision of central clearing mechanisms for over-the-counter derivatives remain essential elements of sound systemic risk management. As can be recalled, Northern Bank faltered not because it was engaged in high-risk investment banking but because of the standard pitfalls of excessive leverage, inordinate exposure to mortgages and dependence on institutional investors for short-term funding. On balance, pension and mutual funds, insurance, and other firms that are engaged with retail investors should not be allowed to deal in hybrid bonds.
To sum up, whenever ostensibly risk-reducing products are sought to be marketed in India, it is worth remembering that innovation in finance cannot eliminate - or even reduce - risk. It can splice and repackage risk through securitisation, derivatives and instruments such as CoCos in such a way that those desirous of taking a piece, but not all the risk, step forward to make the required investments. The problem with hybrid bonds is that there is no constituency protecting the interests of dispersed retail investors even if investments are made on their behalf by institutional investors - hence the need to ring-fence hybrids and allow only hedge fund-type entities to invest in such bonds.
The writer, a former Indian high commissioner to the UK and a professional at the finance ministry and World Bank Treasury, is currently RBI chair professor at Icrier
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
