Contingent Convertibles

Contingent Convertibles (CoCos) are hybrid securities prevalent in the European markets which absorb losses in time of distress. Their primary purpose is to serve as a readily available source of tier one capital for banks in times of crisis rather than having the taxpayer bail the bank out. This aims to make banks more likely to issue equity in stable times, and more prudent in their risk management.  CoCos have two main characteristics, a loss absorption mechanism and the trigger event that activates such mechanism. A CoCo absorbs losses when triggered by converting to common equity or incurring a full or partial principle write-down thus lowering the liabilities. Triggers which enable such conversion can be numerical such as the bank falling below a required capital to assets ratio or based on supervisors’ judgement regarding the bank’s solvency. Banks sell CoCos when their balance sheet is stable and similar to regular bonds, coupons are paid to the investor. However, when such trigger event occurs causing the balance sheet to weaken, the CoCo converts from a bond and coupon payments can be halted as the investor converts from being a creditor to shareholder.

CoCos became popular post financial crisis to avoid needing governments to bail them out in future crisis. In addition, they overcome the issue of investors unwillingness to provide additional capital to banks in times of financial distress. CoCos are a cheap means of improving a bank’s tier one capital ratios and in some countries coupon payments are tax deductible.

Unlike convertible bonds the investor of a CoCo is obliged to the conversion meaning they cannot choose the best time to convert. This mandatory conversion results in an unavoidable transfer of value from either existing shareholders or CoCo holders depending on the conversion ratio. In addition, through anticipating value transfers, classes of investors are incentivised to decline the stock price to lift the chance of conversion and vice versa. This causes systemic instability and taxpayers can find themselves dealing with the consequences and required bailouts (https://www8.gsb.columbia.edu/ideas-at-work/publication/822/caution-on-cocos)

CoCos are perpetual in nature, however come with a call date where the bank has the option to redeem and re-issue. If a bond which is dealing below par is called the investor receives both the coupon and the upside on the price, however if it isn’t called the bond is less valuable as the profits are not realised. This results in market expectations in regards to a call being made having influence on the CoCo price. In addition, regulators can prohibit the call of bonds trading below par as it isn’t economically feasible at the investors detriment.

In theory, they seem promising as in times of stress coupon payments can be halted and the bonds converted to equity, hence since 2013 European banks have issued more than $100b in CoCos that count towards capital for regulatory purposes. However, in February of 2016 Deutsche Bank AG almost missed a CoCo payment which accelerated a vast sell of the bonds and stocks of European banks. This incident brought forth concerns that CoCo bonds make their investors in banks and their debt more likely to sell off in times of distress. CoCos aim to protect the tax payers but do so in the expense of shareholders and bond holders (http://www.bloombergview.com/articles/2016-02-12/the-trouble-with-cocos).





















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On the surface it seems that the rise of CoCos are systemically beneficial to the banking system as they divert losses to the investor rather than the taxpayer. However, concerns have been brought forth that in practice CoCos can result in further worsen a future banking crisis. This is because the effect of a conversion trigger occurring can add downwards pressure to a falling stock price. (http://www.lexology.com/library/detail.aspx?g=a6cdd3f6-0483-48f6-b4f5-4f130a107cec) In addition



When a bank’s capital falls, the balance sheet weakens and a CoCo converts to equity or is written off. CoCos are classified as tier one capital and enable a bank to raise their capital ratio without having to sell new shares. Although

The issue surrounding CoCos is