Contingent Convertibles

High-Yield Hand Grenades

By | Updated July 29, 2016 4:31 PM UTC

It’s a high-yield investment with a hand grenade attached. A security carried gingerly with the hope that it won’t explode, leaving investors in a hole. Welcome to a class of securities that’s all the rage in Europe: contingent convertibles, also known as CoCo bonds. A cross between a bond and a stock, a new type of CoCo is helping banks bolster capital to meet tougher regulation designed to prevent a repeat of the taxpayer bailouts of the financial crisis. Many investors are skeptical that the extra yield they offer really reflects the dangers of a blowup – no one really knows how bad the fallout would be because the trigger has never been pulled. While CoCos are supposed to make financial markets safer, there’s a question about whether regulators may have unwittingly created new and untested risks.

The Situation

The market for Coco bonds seized up in early 2016, as debt sold by Europe’s biggest issuers tumbled on concern struggling lenders including Deutsche Bank might have trouble making interest payments. Prices had rebounded by mid-year and regulators clarified that banks will be able to burn through more reserves before halting coupon payments. The most popular form of CoCo bonds are used by banks to raise additional tier 1 capital, a lender’s first line of defense against financial shocks after equity. Spain’s Banco Bilbao brought the first such bonds to the market in April 2013, and a flood of $108 billion was sold by the middle of 2016. CoCos typically allow a bank to suspend interest payments when it runs into trouble, like when its capital ratios breach levels considered dangerous (that’s the contingent part). If a bank’s financial health deteriorates further, CoCos can force losses onto bondholders: The bonds can lose their value entirely or change into equity (they become convertibles). While hedge funds seeking higher-risk, higher-yielding investments are keen buyers of CoCos, the bonds are also purchased by insurance companies hungry for income as investment returns are crimped by record-low interest rates. The U.K. and other countries have banned sales to individual investors. CoCos paid an average coupon of just under 7 percent in the middle of 2016, roughly double the interest payment on senior bank bonds.

Source: Bloomberg

The Background

Banks are rushing to sell CoCos to prepare for the 2019 implementation of an international agreement known as Basel 3. The accord is being interpreted differently in different markets, so while the European Union opted for CoCos as the debt instrument to boost Tier 1 capital, U.S. banks are employing a form of preferred stock and China’s lenders are using a cross between the two. Even with their explosive growth, CoCos accounted for less than a quarter of the roughly 200 billion euros ($258 billion) in bank capital that euro zone banks raised to stay afloat from mid-2013 to the end of 2014. Regulators cleared the way for the new class of CoCos because they set the stage for bondholders -– rather than taxpayers — to share the pain of bank writedowns and gave lenders a cheap way to raise new funds without diluting existing shareholdings. While the securities are technically bonds (and thus payments can be made from pretax earnings), they display many of the properties of an equity, and can even upend the traditional pecking order that bondholders get paid before shareholders in the event of bankruptcy.

The Argument

Regulators noted that investors often did a better job of predicting which banks would buckle in the crisis than they had themselves. CoCo bonds are designed to harness this “wisdom of the crowd” by putting bondholders on the front line, giving them a vested interest in the health of wobbly banks. The problem is that they are untested: The selloff in early 2016 added credence to concerns that when the first one goes sour and halts coupon payments, investors could suddenly wake up to the inherent risk and flee all CoCos, destabilizing the corporate bond market and possibly even the financial system. Critics charge that the securities are too complex to be properly understood, too varied and too much like equity to be considered bonds. The banks themselves are opaque, definitions of capital vary from bond to bond, and the distance between a bank’s current position and the moment disaster will strike is almost impossible to calculate. When the first one blows, regulators will get a better sense of whether CoCos helped save the banking system, or sink it.

The Reference Shelf

  • A primer on CoCos from the Bank of International Settlements.
  • Andrew Haldane from the Bank of England and Piergiorgio Alessandri of the Bank of Italy set out the theoretical case for CoCos in a 2009 paper. Haldane, the BOE’s chief economist, described them in a speech in 2011.
  • Bloomberg News QuickTakes on Capital Requirements and Too Big to Fail.
  • The EU’s Capital Requirements Directive.
  • The Basel committee’s FAQ on bank capital.

 

First published Oct. 21, 2014

To contact the writers of this QuickTake:
John Glover in London at johnglover@bloomberg.net
Tom Beardsworth in London at tbeardsworth@bloomberg.net

To contact the editor responsible for this QuickTake:
Leah Harrison at lharrison@bloomberg.net