The Moody’s report on changes to its methodology for rating hybrid debt contains a bit of a potential hurdle for the stuff that is meant to replace it: Contingent Convertible securities, or CoCo bonds.
From the report:
After reviewing the features of contingent capital securities, we may decide that they cannot be rated. The securities most likely to fall into this category are those that contractually give the issuer and/or the regulator the discretion to convert the “host” security into common equity. To the extent that there are triggers, our focus will be on whether or not they provide an objective threshold for conversion enabling an investor to reasonably measure the risk associated with conversion.Now, most CoCo bonds, as they’re currently envisioned, will probably have non-discretionary triggers.
Lloyds ECNs (Enhanced Capital Notes) for example — the first new CoCo issue — automatically convert into equity (ordinary or common shares) when a trigger is breached. In the Lloyds case, that is when its core Tier 1 ratio falls below 5 per cent.
But even if Moody’s decides it can rate such CoCos, it looks a bit reluctant:
If we decide that certain types of contingent capital securities can be rated, the analysis will focus on the ability of the “host” to absorb losses as a going concern, the type of loss absorbing capital that the investor may ultimately hold, the probability of conversion, and the loss severity given conversion based on the conversion ratio26. Consistent with all hybrid and subordinated debt ratings, the risk of potential loss is factored into the rating from the outset. An expected loss analysis will be used to position the rating if the probability of a trigger breach resulting in conversion to the underlying loss absorbing capital significantly increases.
. . .
Moody’s expects that new types of hybrid securities will continue to be developed in the future. As before, we will assess our ability to assign ratings to new products based on the preponderance of their fixed income characteristics. For example, it is less likely that ratings will be assigned to hybrids where it is difficult to assess the potential loss to investors such as if the bank has the option to convert a hybrid into common equity. In addition, we will not rate securities for which the amount of promised principal repayment is dependent on the occurrence of a non-credit event27. We may also consider adding an indicator to next generation hybrids should it become clear that there is volatility in the rating that goes beyond our expected loss analysis.
Added with the indexing problem, and the recent rumblings from ratings agency S&P, it looks like CoCos are currently posing more problems than solutions for the financial industry.
Whether such confusion turns out to be just a temporary teething problem, or something more fundamental, remains to be seen.
Related links:
I should not have CoCo-ed? – FT Alphaville
The sweet fix of CoCos? – Gillian Tett, FT