How the Bank Debt That Everyone Is Talking About Works: Q&Aby
CoCo bonds were created after the crisis to prevent bailouts
Value of bank CoCos are falling amid concern about payments
Deutsche Bank AG’s attempts to reassure investors about its ability to pay its debts have shone a spotlight on a type of security that didn’t exist as recently as three years ago. Here’s what you need to know about CoCo bonds. For more background, check out our QuickTake.
Deutsche Bank may struggle to pay coupons to investors in its Additional Tier 1 securities, also known as CoCos, in 2017, analysts at CreditSights Inc. wrote Monday. This helped trigger a sell-off in the bank’s shares and bonds, while the cost to insure against a default on its debts climbed. The bank issued a statement saying it had plenty of capacity to make the interest payments.
What is a CoCo bond?
A contingent convertible capital instrument, or CoCo, is a type of bond designed by regulators after the financial crisis. The bonds allow banks to skip interest payments without defaulting, and they’re designed to convert to common equity or suffer a principal writedown if a bank runs into trouble. This provides a buffer in times of stress while inflicting losses on CoCo investors.
So how does it work?
CoCos typically allow a bank to stop interest payments when it runs into trouble, like when its capital ratios breach levels considered dangerous (that’s the “contingent” part). If the bank’s financial health deteriorates further, CoCos can force losses on bondholders. The bonds can lose their value entirely or change into common stock (that’s the “convertible” part).
How do banks determine whether they can pay?
This is where it gets really technical. To make optional payments such as dividends, bonuses and coupons on CoCos, banks must calculate their “available distributable items," or ADIs. Deutsche Bank, which has to make the calculation based on its audited, unconsolidated accounts under German GAAP, has thinner coverage than other major banks, prompting the current volatility.
Why did regulators create CoCos?
During the financial crisis, taxpayers had to inject billions of dollars into failing banks, while investors in those lenders’ bonds were often fully repaid. Officials wanted to create ways to avoid this in the future.
What’s the issue now?
The market is only three years old and the securities are untested. Investors have three concerns given banks’ weak earnings and market volatility: that lenders will have to halt coupon payments, that they won’t buy back the securities as soon as hoped, and most of all that there will be a loss of principal.
What’s the fallout at Deutsche Bank?
The bank’s 1.75 billion euros ($1.98 billion) of CoCos fell to a record low of 70 cents on Tuesday versus 93 cents at the start of the year. Its senior bonds have fallen as low as 89 cents, while its shares have almost halved this year. Credit default swaps that pay out if Deutsche Bank defaults on its subordinate debts have more than doubled so far in 2016.
How about other CoCos? What’s going on with them?
Banks have issued about 91 billion euros of CoCos since April 2013. Investors piled into them last year, searching for yield, and were rewarded with returns of about 8 percent. Those gains have been all but wiped out in less than six weeks this year. Deutsche Bank isn’t alone; UniCredit SpA’s 1 billion euros of 6.75 percent bonds dropped to a record-low 72 cents after the Italian lender reported a decline in quarterly profit. Bonds issued by Barclays Plc, Lloyds Banking Group Plc and Royal Bank of Scotland Group Plc also fell.
Is there a broader risk?
The current volatility could damp investors’ appetite for CoCo bonds the next time lenders try to issue them, and a sell-off might bleed into the wider credit markets.