Moody's looks to cash in on lucrative CoCo business

Fri May 2, 2014 10:00am EDT

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By Aimee Donnellan

LONDON, May 2 (IFR) - Moody's is set to reverse course and begin rating the riskiest contingent capital bonds before the end of the summer, entering a market that has fast become too big, and profitable, to ignore.

The ratings agency is seeking market feedback over the next month about expanding its ratings coverage of CoCos to include high-trigger bond instruments. Up until now, it has only rated bonds that write down or convert to equity when a bank hits a 5.125% trigger.

According to Moody's, contingent capital is now a much more transparent market with a broader investor appeal, which has driven it to reevaluate its position.

"In response to the growth of the market, investors are now actively requesting our opinion ratings on CoCos, different instruments which we haven't seen before," said Johannes Wassenberg, a banking managing director at Moody's.

"We now feel more comfortable in the risks of the market but are still aware that the instruments have never been tested through a crisis, so we need to be cautious."

The CoCo market is expected to include 65bn worth of Additional Tier 1 and Tier 2 securities this year - a lucrative business for a ratings agency that can charge as much as US$100,000 (72,000) per rating it provides.

"This is a huge swing in the pendulum for Moody's," said a hybrid capital bank expert.

"They are now looking to rate absolutely everything, even when banks haven't solicited them to do so. This will cement the standing of CoCos in the more mainstream market but is unlikely to have any impact on price or investor appetite."

Moody's is also proposing to create a cap of Ba1 for the ratings of high-trigger bonds, a move that prevent banks from issuing an investment-grade CoCo.

"This might be most relevant for some of the Nordics, where they may have high triggers but their ratings and capital strength might otherwise still give them a shot at an investment-grade Additional Tier 1 rating," said the banker.

CoCos, often known as hybrid bank capital, have equity-like features but are cheaper than equity and could help banks meet tough new rules to prevent a repeat of the 2007-2009 financial crisis when taxpayers bore the brunt of bank bailouts.

Moody's has been on the sidelines of the high-trigger CoCo market since its inception, preventing it from winning fees from very active banks like Barclays and Credit Agricole that issue bonds with 7% triggers.

Moody's main concern with high-trigger instruments lies with there being a risk of having a junior debt/preferred equity claim should the bank become non-viable, at precisely the same time as potentially risking conversion to equity or write-down.

Moody's still appears cautious about instruments that are first in the firing line if a bank runs into trouble and needs to recapitalise.

"This is an untested class of bank securities and there remains some degree of uncertainty as to when conversion or write-down could be triggered," Moody's said.

"The likelihood of a trigger breach - even though closely tied to a deterioration in the bank's financial condition - is by design meant to be higher than the likelihood of a bank-wide failure."

EVEN KEEL

In what appears to be good news for banks looking for an additional rating, Moody's is also looking at removing a one-notch rating cut for Additional Tier 1 and Tier 2 relative to old-style securities.

"We initially implemented the one-notch differential to capture the additional uncertainty regarding the timing of an impairment event being triggered prior to the point of non-viability," Moody's said.

"However, our ongoing analysis of market developments suggests that this additional risk is lower than originally thought and, for Additional Tier 1 securities, does not justify a full notch adjustment relative to the ratings on corresponding traditional Tier 1 securities."

If Moody's goes ahead with this proposal, approximately 20 securities, mostly Additional Tier 1 bonds, could be upgraded one notch.

"Given the importance of this emerging asset class and the degree and nature of credit risk posed to investors, we intend to express our opinion to the market through rating these securities where possible," Moody's said in its report.

Market participants have until June 2 to send in comments on the proposed changes to the ratings agency's practices. (Reporting by Aimee Donnellan; Editing by Alex Chambers and Philip Wright)

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