CoCo Bonds Joining the Party

Deutsche Bank has joined European banks in issuing a popular new type of bond, in which investors will have a stake in any potential losses. But it comes at a high cost.
When life throws lemons at you -- sell lemonade!

It has taken a while for Germany to join the European CoCo bonds party. Deutsche Bank is leading the way.

Germany’s largest bank on Wednesday said it had raised €1.2 billion ($1.5 billion) in a new and innovative type of bond that would see investors lose their money if the bank runs into serious trouble. The placement brings its total issuance of such bonds this year to nearly €5 billion.

The bonds, known as Contingent Convertible Bonds, or CoCos, are the latest popular innovation for banks to meet the increasing demands stemming from regulators since the 2008 financial crisis. For a bank, they act as something of a hybrid between traditional bonds – where investors face losses only if a bank is insolvent - and issuing equity, where the investment’s value rises and falls with a bank’s share price.

In 2015, we will see European banks taking many capital measures, such as issuing CoCo bonds, because regulators continue to require thicker capital cushions. Jörg Oliveri del Castillo-Schulz, Banking expert, Roland Berger consulting

Investors in CoCo bonds by contrast will lose their money only if a banks’ equity ratio – the amount of reserves they hold relative to their risk-weighted assets - falls below 5.125 percent. The bonds then become worthless and instead contribute to the bank's recovery.

This is unlikely to happen in the case of Deutsche Bank, which currently has an equity ratio of 14.7 per cent. But given that money could potentially be lost, the CoCo bonds still come at a higher cost than traditional bonds: Investors are charging 7.5 percent interest to participate in Deutsche Bank’s latest offering, the bank said in a statement.

Financial experts warned this high cost could make it more difficult for banks like Deutsche Bank to become profitable. The bank posted a €92 million quarterly loss in the July-September period as it also continues to battle a series of legal challenges that required the bank to set aside some €3 billion for potential losses.

Still, it is an innovation that has become increasingly popular in Europe, where many banks still have lower capital ratios and more trouble raising equity than their U.S. counterparts.

European banks have already issued a record $31.8 billion in CoCo this year, according to the financial website Dealogic. British banks have led the way, with five banks issuing $8.3 billion in total. Britain’s Lloyds bank was the first financial institution to issue such bonds back in 2009.


CoCo bonds-02


According to banking expert Jörg Oliveri del Castillo-Schulz, demand for these kinds of innovative financial solutions will only increase next year as banks will need more and more reserves to satisfy the conditions imposed by regulators.

"In 2015, we will also see European banks taking many capital measures, such as issues of CoCo bonds, because regulators continue to require thicker capital cushions," said Mr. Castillo-Schulz, a banking expert with the Roland Berger management consulting firm.

In Germany, only Deutsche Bank has seriously dabbled in the market. This week marked the second time Deutsche Bank has turned to such bonds, after it became the first German bank to enter the market earlier this year by raising €3.5 billion in May. The current transaction satisfies its goal of raising €5 billion with these types of securities. The bank also raised €8.5 billion in fresh capital from investors earlier this year.

This time around, Deutsche Bank sought to attract the attention of U.S. investors by issuing the bonds in U.S. dollars. The issue was approved by the U.S. Securities and Exchange Commission (SEC), which financial experts said should translate into substantial buying interest among investors in the United States.

Deutsche Bank’s Chief Financial Officer Stefan Krause in a statement Wednesday said the issue had received “strong interest from investors around the world.”

Like other European banks, the increased use of CoCo bonds mark a reaction by Deutsche Bank to regulators' new and tougher capital rules. Stricter requirements are intended to prevent taxpayers from being asked to pay for bank bailouts in the future.



Deutsche Bank has never required a government bailout. But as one of the world’s largest banks, it is considered “too-big-to-fail” by regulators because it could upset the financial system if it did. That means it has to build an especially large capital buffer compared to other banks.

With the current issue, Deutsche Bank is expected to slightly raise its leverage ratio – the percentage of capital it holds compared to how much money it lends - to 3.3 percent.

This should calm regulators who are paying more and more attention to a bank’s leverage ratio as a key measure of how much risk a bank has taken on. Mr. Krause, in an analyst call earlier this month, had already said the bank was preparing for regulators to raise the leverage ratio for major banks.

"With 3.2 percent, we are currently fulfilling the minimum leverage ratio requirements. But we have to build an even larger buffer here, because we expect the current minimum ratio to be raised above the 3-percent threshold," Mr. Krause explained.

The bonds are attractive to investors looking for something a little more risky. Many are increasingly prepared to take these risks because they can’t earn enough money in the current low-interest environment. Other German banks are therefore also starting to get in on the act.

Aareal Bank, a private bank in Germany, also placed a CoCo bond on the market last week. The €300-million bond issue generated more than €1.5 billion in buying orders. The Wiesbaden-based bank set the interest coupon at 7.625 percent, below the 8-percent that the bank had initially expected to pay. Aareal, which specializes in property finance, issued the bond to make up for money it had repaid the government in late October.

But the high cost of the new bonds also causes problems for banks, said Mr. Oliveri del Castillo-Schulz. Having a broader capital base will also make it more difficult for banks to achieve suitable returns for their owners. For this reason, he explains, the pressure on business models to achieve higher revenues at a lower cost basis will remain in place.


Peter Köhler covers financial firms including Deutsche Bank for Handelsblatt in Frankfurt. Christopher Cermak writes about finance and economics for the Handelsblatt Global Edition in Berlin. To contact the authors: [email protected] and [email protected]