CoCo Bonds: Meaning
European financial institutions are the primary issuers of contingent convertible bonds which are also called CoCo bonds. These debt instruments operate in a manner that mimics traditional convertible bonds. They are tethered to a specific strike price which if breached is capable of converting the bond into equity or stock. Individual investors hailing from Europe and Asia along with private banks are the primary investors of these bonds. Now, you might be wondering what is a CoCo bond? CoCo bonds can be understood to be high-yield, high-risk products that are popularly used tools with regard to European investing. They are also called enhanced capital notes (or ECN). They serve as hybrid debt securities that bring with them specialized options that provide the financial institution responsible for issuing them with cushioning to help absorb a capital loss.
Examining the Origins of CoCo Bonds
When looking at the banking industry, CoCo bonds come in handy as they help banks with their balance sheets and allow them to convert their debt to stock in case certain capital conditions arise. Contingent convertibles were created as a means to provide assistance to undercapitalised banks and to prevent the occurrence of financial crises such as the global financial crisis of 2007-2008. American banks have not made use of CoCo bonds so far as they haven’t been introduced to the American banking industry.
Their popularity rose in the world of investing as they helped financial institutions meet the Basel III capital requirements. Basel III refers to a regulatory accord that outlines a set of basic standards that the banking industry is required to maintain as their bare minimum. The primary goal of this regulatory accord was to enhance the management of risk, increase supervision and improve the regulatory framework that governs critical aspects of the financial sector.
These standards stipulate that banks must maintain a certain amount of capital or money. This is because this figure will allow them to better withstand financial crises and be able to absorb unexpected losses that may arise from loans as well as from investments. Capital requirements were also tightened under this agreement by restricting the form of capital a bank could list under its varied capital tiers and structures.
Bank capital may exist in the form of Tier 1 capital which is the highest-rated capital that is made available to offset poor loans that might mar a bank’s balance sheets.
Understanding What CoCo Bonds Are
There exists a sharp contrast between contingent convertibles that have been issued by a bank and ordinarily convertible debt issues.
Convertible bonds are characterised by bond-like characteristics and pay their holders an ordinary rate of interest. They gain priority in instances of the underlying business defaulting or not paying up its debts. Convertible bonds also permit bondholders to convert their bonds into common shares at predetermined strike price thereby allowing them to have share price appreciation. This strike price refers to a certain stock price level that must transpire in order for the conversion to be granted. Investors stand to benefit from these debt securities as their bonds can be converted to stock at a point in time when the company’s stock price is rising in value. As a result, investors can benefit from the advantages that bonds provide in terms of their fixed interest rate and the potential perk of capital appreciation via rising stock prices.
CoCo bonds expand upon the basic premise of convertible bonds while modifying their terms for conversion. Operating in a manner similar to that of other debt securities, CoCo bonds provide their investors with specified interest payments that are fixed over the course of the bond’s life. Further, like convertible bonds, CoCo bonds are subordinated and contain certain triggers that outline when the conversion of debt holdings to common stock is a possibility. These triggers can take any one of the following forms.
- Instances of underlying shares of the institution in question reaching a certain level
- The need to meet regulatory capital requirements by the bank in question
- Instances of managerial or supervisory authority being demanded
Banks and Contingent Convertibles
Contingent Convertibles are employed by banks in a manner that differs from corporations that use these debt securities. Banks are governed by their own parameters that govern the conversion of these bonds to stock. These triggering events can include the following.
- The value of the tier 1 capital for a given bank
- The supervisory authority’s judgement
- The value of the underlying stock shares of the bank
CoCo bonds help banks absorb financial losses. As opposed to simply converting bonds to common shares owing to a rise in the price of the stock alone, CoCo investors agree to be given equity in lieu of regular income via the debt when the bank’s capital ratio dips below the regulatory standards. That being said, the stock price can fall instead of rising. In the event that a bank suffers from financial difficulties and requires capital, it will be evident in the value of its shares. Owing to this fact, convertible contingent bonds can result in investors having their bonds converted into equity while the stock’s price falls. In such circumstances, the investors face the risk of incurring losses.
Undercapitalised banks stand to benefit tremendously from contingent convertibles as they feature embedded options that permit banks to meet capital requirements while limiting capital distributions simultaneously.