German CoCo Bonds
The term “CoCo bond” stands for “contingent convertible bond”. German CoCo bonds are risky instruments, but generally provide high yields to investors. They are structured as convertible bonds (Wandel-Schuldverschreibungen) with a contingency element, which means that in contrast to a regular convertible bond, the bondholders do not have the conversion right. Instead, the issuer has the conversion right - or even a conversion obligation - if a certain pre-defined trigger event occurs, or there is a conversion mechanism which is triggered automatically.
Historically, the German Stock Corporation Act (Aktiengesetz, “AktG”) only allowed for the issuance of regular bonds, including convertible bonds, but did not expressly mention the issuance of CoCo bonds. It was therefore uncertain whether the issuance of such bonds by German stock corporations (and similar German companies) was legally admissible. In 2016, the AktG was amended and now expressly allows for the issuance of CoCo bonds. As such, the German bond market has seen first issuances of this rather new and interesting type of instrument.
Different Types of German CoCo Bonds
- Regulatory CoCo Bonds:
The reform of the AktG was in particular driven by requirements of the EU Capital Requirements Regulation (EU) No. 575/2013 and the EU Capital Requirements Directive No. IV 2013/36/EU (“CRR/CRD IV”) as well as the EU Bank Resolution and Recovery Directive 2014/59/EU (“BRRD”). Under the CRR/CRD IV, European banks are required to bolster their capital by issuing several layers of instruments, which will be written down or converted if the relevant capital layer falls below the prescribed thresholds. As instruments of the so-called “Additional Tier 1 Capital (AT-1)”, the banks need to issue bonds with a write-down mechanism and/or CoCo bonds, corresponding to at least 1.5% of a bank’s risk-weighted assets. The CoCo bonds will be converted into shares (Common Equity Tier 1, “CET-1”) if the CET-1 falls below 5.125% of the bank’s risk-weighted assets.
In addition, pursuant to the BRRD and the German law implementing such directive, the German regulator can use the so-called “bail-in tool” by, in effect, requiring a bank to write-down or convert the relevant capital instruments in circumstances where a bank has fallen into distress and has reached the “point of non-viability”. A bail-in will be implemented in accordance with the following waterfall: (i) CET-1, (ii) AT-1, (iii) Tier-2 (“T-2”), and (iv) other instruments and liabilities which are eligible for a bail-in. It is important to note that in case of a positive net value of the distressed bank, a conversion has priority over the more severe write-down.
Accordingly, the amended AktG expressly mentions the following types of CoCo bonds:
- CRR/CRD IV-driven CoCo bonds “to fulfill regulatory requirements under banking laws”; and
- BRRD-driven CoCo bonds to meet “restructuring or resolution requirements”.
Before the amended AktG entered into force in 2016, issuances of so-called “CoCos” by Deutsche Bank (in 2014) and a few other German banks were reported by the press. Indeed, these bonds with write-down mechanism were issued as AT-1 instruments, but as they lacked a conversion mechanism, they were technically not CoCo bonds (although the term was often used in this context).
2. Other Types:
In addition, the AktG expressly mentions CoCo bonds issued by a German stock corporation with a conversion right of the company in case of “imminent illiquidity” or for the “prevention of an over-indebtedness”. Other examples of “model” types of German CoCo bonds (although not expressly recognized in law) are bonds that contain one or more of the following conversion triggers:
- Incurrence of a material loss due to a severe natural disaster;
- Disruption/shortfall of the average stock market price of the issuer’s shares or CDS spreads;
- Financial covenant breach; or
- Simply, a fixed conversion date as a trigger.
Examples of German CoCo Bonds:
The following are examples of CoCo bonds recently issued under German law since the amended AktG has entered into force:
- UmweltBank AG: CoCo bond with a conversion mechanism (AT-1 instrument), EUR 40 million, 2.85% p.a.;
- Bayer: CoCo bond to refinance the Monsanto takeover, EUR 4 billion, 5.625% p.a., with a conversion obligation of the issuer in 2019; and
- Grammer AG: CoCo bond issued to a strategic Chinese partner, EUR 60 million, 1.625% p.a., with a conversion mechanism one year after the issue date.
European Market for CoCo Bonds and AT-1 Instruments
Plunge in 2016
In 2016, European AT-1 bonds came under pressure due to a general loss of confidence in the financial state of certain European banks. There was uncertainty in the market as to whether the regulators would subordinate the coupon payments under the bonds to the so-called “capital buffers”. Broadly speaking, in addition to the CET-1, banks need to build up capital buffers outside periods of stress which can be drawn down as losses are incurred. When buffers have been drawn down, one way banks need to rebuild them is through reducing distributions.
Market regained in 2017
Interest in AT-1 bonds returned in 2017 because the market perception was that the European banks’ performance was improving. Importantly, the European Central Bank (in line with a proposal by the EU Commission for a draft bill) clarified that AT-1 coupons are indeed preferred vis-á-vis buffers, i.e. buffers need to be rebuilt from other sources (e.g. share dividends, bonuses) before AT-1 coupon payments are to be cancelled. As at May 2017, approx. €150bn of AT-1 instruments have been issued (CoCo bonds and bonds with write-down mechanism).
A new draft position has been prepared by the EU Council of Ministers under the Maltese presidency which proposes to abandon the preference of AT-1 coupons so that regulators have more flexibility. It remains to be seen whether, and in which form, this proposal will finally be passed by the EU Parliament, and how the market is going to react to this.
Typical Terms and conditions of German CoCo Bonds
Regulatory CoCo Bonds:
For CoCo bonds that are issued as AT-1 instruments, the CRR/CRD IV requires that certain terms be included. In particular, AT-1 CoCos cannot be secured or guaranteed, and run for an indefinite term. A termination and a repayment of the notes is always at the discretion of the issuer and is only possible five years after the issue date at the earliest, provided that the instrument will be replaced with an equivalent instrument (if necessary) and the competent regulator has given consent. Likewise, interest is always payable at the issuer’s discretion, e.g., the issuer will cease to pay interest to prevent a shortfall of the prescribed CET-1 quota, without triggering an event of default and without being required to pay such retained interest at a later point in time. Due to this risk profile, German AT-1 CoCos typically have coupons ranging between 5% and 8% p.a..
Non-regulatory CoCo Bonds:
The AktG does not particularly restrict the terms and conditions of non-regulatory CoCo bonds, which leaves more room for creativity in their design and drafting.
The issuance of CoCo bonds may require a prospectus according to the German Securities Prospectus Act (Wertpapierprospektgesetz, “WpPG”). However, due to their risk profile, CoCos are typically offered only to “qualified investors”, in which case no prospectus requirement applies in general.
Although the German CoCo bond market is still relatively new, it is expected that we will see more issuances of this type of instrument in Germany and across the EU going forward. The regulatory landscape continues to be subject to change, and so we can expect a number of interesting issues to arise in the future, such as the current debate around abandoning coupon preference.