CoCo Coupons May Receive Payout Priority to Disarm Debt Grenade

  • `Dividend stoppers' allowed in jurisdictions outside of EU
  • Market turmoil prompts effort to ease conditions on AT1s

European regulators signaled they may be considering linking interest payments on banks’ riskiest debt to dividend payouts, investors and analysts said, as authorities seek ways of jamming the pin a little further into the hand grenade that’s attached to the securities.

A so-called dividend stopper, which would bar dividend and bonus payments unless coupons are paid on additional Tier 1 bonds, could be a solution for the European Commission as it seeks to reassure the market, investors said. A staff note to an expert working group obtained by Bloomberg News last week suggests holders of AT1 securities, also known as CoCos, deserve “particular protection relative to the other stakeholders concerned.”

While dividend stoppers are permitted by all major jurisdictions outside the European Union, they are banned by EU regulations. That may force European regulators to stop short of a stopper and instead issue guidance that AT1 coupons should be paid before other optional payments are made. Authorities are looking for ways to reassure investors after concern about banks’ ability to make coupon payments rattled the CoCo market earlier this year.

“It’s quite clear that AT1s are very sensitive to coupon risk, perhaps over-sensitive,” said Roger Francis, an analyst at Mizuho International Plc in London. “Allowing dividend stoppers would be a good way to increase investor confidence in European AT1s, and this would be our preference. Failing that, guidance would help to create an explicit waterfall, which would go most of the way to meeting the need for clarity on payments.”

Plunging Prices

Responding to the 2008 crisis, global regulators created undated AT1 bonds with optional interest payments to draw debt investors into banks’ capital structures with the aim of having them sound a warning bell should lender’s capital levels, or behavior, indicate trouble ahead. In Europe, that resulted in notes that are impossible to default on and which have strict conditions attached to coupon payments, potentially meaning an issuer could pay its shareholders or staff, while refusing to pay holders of the securities.

Concern that regulators might not allow lenders including Deutsche Bank AG and UniCredit SpA to pay coupons on their AT1s roiled the $102 billion market for the securities in January. The turmoil sent the average price of the securities in Bank of America Merrill Lynch’s CoCo Index to as low as 88.8 cents on the euro, from 100.3 at the beginning of the year, and has blocked issuance by European Union banks since mid-January.

“Linking payments of coupons and dividends would make it clear that equity can’t be paid before debt and that the hierarchy will be respected,” said Gregory Turnbull Schwartz, an Edinburgh-based fixed-income manager at Kames Capital, which runs about $82 billion. “A skipped dividend is just that and can be recovered though higher payments later. An unpaid coupon is gone forever.”

First Deal

The link is permitted under the global standards signed off on by the Financial Stability Board, the global regulatory body chaired by Bank of England Governor Mark Carney. AT1 debt issued by Swiss banks UBS Group AG and Credit Suisse Group AG has the feature, which has helped reassure bond investors that their claims will be respected before those of more-junior creditors. UBS, Switzerland’s biggest bank, is in the market Monday with the first AT1 deal from a European lender since January.

The European Union instituted the ban on stoppers to end confusion about links between securities that became apparent during the crisis.

Under European rules, when losses at a lender mean it can’t meet its full capital requirements it has to calculate its “maximum distributable amount,” or MDA, according to a set formula. Once the MDA is decided, it must then restrict optional payments on a sliding scale depending on the extent of the loss, to retain capital within the firm. The bank can choose which payments it doesn’t plan to make.

“Banks aren’t allowed to promise to pay AT1s before dividends or bonuses, they can only say ‘Our current policy is to do so’,” Francis said. “Policies can change, so the value of any commitment is pretty low. Dividend stoppers, on the other hand, are highly prized.”

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