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Bittersweet 'CoCo': A précis on contingent convertible bonds

Publication Date: 16 Jan 2019 - By Marc Ross By Marc Ross
Actionable
Differentiated

Investment Strategies Convertibles Global Financial Services

Born of the financial crisis of the mid aughts, contingent convertible bonds or 'CoCos' look to be an interesting, albeit untested risk management tool designed to forestall another regulatory boondoggle. Can they do it? A closer look at the product and marketplace reveals some interesting details.

As their name indicates, CoCos are bonds convertible into common equity to create a safety mechanism upon the bank’s or insurer’s inability to satisfy specific financial criteria (e.g. a failure to satisfy minimum capital requirements to the point that the institution risks no longer being a going concern) or at the discretion of the regulatory body that oversees them for essentially the same reason.

Such regulatory discretion could vary and there exists the risk that the overseer could pull the trigger prematurely. The appeal of these bonds to financial institutions is their lower cost of issuance and often favorable tax treatment. The appeal to the regulators is their ability to satisfy capital buffer or shock absorber requirements that came out of Basel III.

Additionally, these bonds could motivate shareholders to monitor the institution’s behavior for and steer it away from unduly risk-seeking activities as well as provide liquidity during financial stress. The risk to both parties is that there has yet to occur an event that would trigger convertibility. How a conversion would take place remains unknow as are the risks of contagion whereby idiosyncratic bank risk becomes systemic and consequent economic disruption ensues.

Niggling details

Afforded treatment as regulatory capital, CoCos exist to absorb losses by acting as a buffer either through conversion or write-down upon the triggering event, the criteria for which are the subject of academic and professional debate. Given the relative youth of this subset of fixed income – the first issued in 2009 with none having been exercised to date – questions surround how and when the loss absorption mechanism would deploy (e.g. conversion or write-down).

Were the bank or insurer to become viable again, could it recover the write-down? What would be the outcome should a regulator force conversion prematurely? These types of bonds have been issued and traded in Europe and the United Kingdom, but not in the United States where regulation, accounting and the tax code preclude their issuance. The main buyers have been retail investors and private banks.

Institutional interest has lagged due to the absence of consistent and complete credit ratings resulting from heterogeneous regulatory treatment across jurisdictions and valuation concerns due to the existence of the discretionary triggers.

Indeed, approximately half the issues are unrated and there exists tension between regulation of the issuer and of the prospective buyer. While an actual trigger has yet to be exercised, secondary market behavior of some of these issues gives pause.

Specifically, Deutsche Bank’s unhappy tidings on two occasions in 2016 – a negative earnings announcement in January that caused a frisson amongst investors over the possibility of missed coupon payments on its CoCos, and later in September, the bank’s receipt of a fine from the US Department of justice – caused a swoon in prices and a corresponding spike in the yield-to-maturity of Deutsche’s senior securities and CoCos along with those of most major European banks, though nothing so egregious as to approach the point of exercise occurred.

The overreaction of CoCos to these two events underscores the volatility of this subset of fixed income whose long-term viability remains unproven. Caveant emptores.

Disclosure:

I have no positions in any of the securities referenced in the contribution

I do not use any non-public, material information in this contribution

To the best of my knowledge, the views expressed in this contribution comply with UK law

I agree with the terms and conditions of ReachX

This contribution is for informational purpose and does not constitute investment advice nor is it an offer to sell or buy, nor is it a recommendation for any security.

Marc Ross

 

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