The word ‘coco’ may invoke thoughts of a certain chocolatey breakfast cereal, or perhaps a French fashion house, but in recent times, it has gained another connotation – risky bank bonds.
Contingent convertible bonds or ‘CoCos’ are complex debt instruments that can be converted into equity or even written off if the issuer’s capital drops below a certain threshold. CoCos are considered to provide a capital buffer and aren’t new on the scene as an alternative way of raising capital: issuance of CoCos has risen sharply since 2010. But the FCA temporarily banned the controversial bonds last year due to their complexity and the potential threats they pose to regulators and investors.
Announcing a bank as weak can cause panicThis week,
The Economist explained how CoCos have been “billed as the best of both worlds”, those worlds being equity, preferred by regulators, and debt, preferred by banks. “These fancy bonds have the upsides of debt in good times, but provide a cushion in a crisis,” it wrote. However, the piece was quick to point out the risks of these new hybrid issuances.
As CoCos convert when the issuing bank dips below a certain capital threshold, it is essentially the same as “announcing that a bank is weak”, which “can cause panic”.
The article outlined further risks: “A conversion also imposes sudden losses on bondholders, who find themselves holding shares worth much less than the bonds that spawned them. If the bondholders are themselves in distress, those losses can reverberate around the financial system.”
It went on to describe an alternative to CoCos, the more prosaically named equity resource note (ERN). “Like a CoCo, an ERN functions as debt in normal times. But the trigger for the conversion is the bank’s share price, rather than a regulatory measure of capital. When the share price falls by enough … the bank can make repayments on the bond with new shares rather than with cash.”
This evades the pitfalls of CoCos, according to the article. “There is no uncertainty about how regulators will behave. Abrupt losses are minimised: investors can see when the share price is nearing the trigger, and if it recovers, cash payments resume. Because the new shares are worth no more than the cash saved, ERN conversions should shore up a bank’s share price.”
The Economist opinion Running the risk of burning through buffersWriting for
Investment Week, Filippo Alloatti, Senior Credit Analyst at Hermes Investment Management, also warned of the dangers of over-dependence on this new popular type of issuance. Alloatti urged investors to consider all the risks before taking the plunge.
“The market for CoCo investing is still in its nascent stage,” he wrote. “There is no clear standardisation or uniformity among additional tier-1 securities, and fundamental analysis of bank assets of is crucial. So is the ability to forecast the size of the future buffers that banks will require, and their ability to generate organically enough capital to preserve them.
$138bn
worth of CoCo bonds were issued last year
“As credit investors, our profit and loss modelling skills must enable us to discern which banks run the risk of burning through their buffers. This is what matters the most,” advised Alloatti. “Investors cannot rely on the longevity of the capital defences presented by banks on the first day of a roadshow,” he added.
Investment Week comment Emerging-market concernsDespite the apparent hazards, CoCos are proving extremely popular. Issuance rose to $138 billion last year. No doubt the increase had been spurred by the prospect of banks achieving a cash buffer.
But in a
Wall Street Journal article, Fiona Law reported on how a major buyer of CoCos, Pacific Investment Management Co. (Pimco) is steering clear of those issued by emerging-market lenders.
Philippe Bodereau, Global Head of Financial Research at Pimco, explained why. “If you look at some big bank issuers [in emerging markets], there is some deterioration in their fundamentals.” By contrast, he added “in Europe and the US, [banks have] spent the last six years deleveraging. They have made a lot of efforts to clear debts and what are left on their balance sheets are relatively low-risk assets.”
Of Chinese banks, Bodereau said: “In general, we are sceptical on the reporting of [nonperforming loans] in China, and our credit analysts spend a great length stress testing balance sheets.”
This has left space for other major players to move in. Rick Rieder, Chief Investment Officer at BlackRock, said: “There’s nothing cheap about fixed income in the world today … and it makes sense to own some bank capital securities (to enhance returns),” including those issued by Chinese banks.
He added that contingent convertible bonds have been attractive, “especially in an environment where regulators are [building up] safety to the banking system … It will continue to be a good place to generate yield”.
Wall Street Journal article
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