What Are CoCo Bonds?

A Look at Europe’s Potential Banking Problem

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Turbulent financial markets tend to introduce new financial jargon. In early 2016, European banks like Deutsche Bank, Santander, and UniCredit found themselves under pressure to make payments on a unique type of bond known as a “coco” bond.

What Are Coco Bonds?

Contingent convertible bonds – or coco bonds, for short – are a type of convertible debt that turns into equity when a specified event has occurred.

While normal convertible bonds have a strike price for their conversion into equity, coco bonds have a second upside contingency that must be met before the investor can make the conversion. The bonds are also known as tier one contingent convertible bonds or additional tier one capital – or AT1 bonds.

Coco bonds become extremely popular following the 2009 European sovereign debt crisis when governments were forced to bail out banks. Coco bonds were encouraged as a way to build up tier one capital to strengthen a bank’s balance sheet and meet new regulatory requirements. If a bank’s capital fell below a certain threshold, the coco bonds would be converted into equity or be written off, which would only affect sophisticated lenders to banks.

Regulators hoped that these sophisticated lenders would be able to properly assess risks and limit the potential impact of a conversion or write-off. Banks would be protected entirely from these events, since the worst case scenario would be dilution to their stock.

Credit default swaps (CDS) and other tools could be used to insure against losses for these bonds and ultimately ensure the stability of the wider financial system.

Potential Coco Bond Risks

Coco bonds became the riskiest type of debt issued by banks, with a majority of them being considered non-investment grade by ratings agencies.

Coupon rates reached 6% to 7% in order to compensate investors for these risks, compared to less than 1% yields for the senior debt held by many banks. Not surprisingly, investors eagerly jumped into these bonds in the subsequent low interest rate environment as a way to build up portfolio yields.

Problems began to surface in early-2016 when investors began questioning whether or not major banks would every exercise their option buy back these bonds. Since banks would have to issue new costlier debt to meet regulatory requirements, they aren’t exactly keen on doing so as many had expected. This could lead to a downward revaluation of these bonds since perpetuity bonds are worth less than bonds that have a fixed maturity date.

These dynamics could also lead to a crisis of confidence in financial institutions. If investors rush to buy protection on coco bonds to limit their losses from this revaluation, it could be seen as a lack of confidence in banks’ ability to make payments on the bonds, which could ultimately become a self-fulfilling prophecy. These events are only beginning to play out in 2016, but the popularity of coco bonds as a tool to bolster required capital could be dwindling.

Key Takeaway Points

  • Contingent convertible bonds – or coco bonds – are a type of convertible bond that has a secondary contingency before investors can convert it into equity.
  • Coco bonds became very popular during the 2009 European sovereign debt crisis as a way to raise capital and strengthen banks with little structural risk.
  • Investors were eager buyers of coco bonds during the ensuing years after 2009 thanks to record low interest rates and a flight to yield.
  • Investors have started to question the value of these bonds in early 2016 due to uncertainty about when they’d be paid back and banks’ abilities to make payments.