A new type of financial instrument set up in the wake of the financial crisis may appear attractive, but investors should be wary.
Contingent convertible bonds, also known as CoCo bonds, are highly risky convertible bonds that are automatically converted into a bank's equity capital or are depreciated when their capital buffers fall below a certain threshold. Investors in CoCo bonds are taking a high risk, because they could lose everything. Conversely, if things go well they can receive a lucrative return of about 6 percent.
There is a high barrier to entry – a minimum investment volume of €100,000 ($109,000) – and for good reason. It appears that not even professional investors seem to know exactly how the bonds work. There is no other way to explain recent fears that Deutsche Bank may not pay out on its CoCo bonds, even though the bank's core capital ratio is "miles away" from the trigger threshold. The bank did pay, but the whole incident shows that CoCo bonds apparently trigger confusion.
So who exactly benefits from them?
It appears that not even professional investors seem to know exactly how the bonds work.
It is attractive to banks to be able to fill up their core capital with CoCo bonds instead of equity in the form of stocks or retained earnings. The interest paid on the coupons can be claimed as tax deductions, unlike dividend payouts. Capital costs are low, and the issuing bank may suspend interest payments under certain conditions.
If the trigger threshold is reached and bank regulators approve, the bonds, depending on how they are structured, either become equity capital of the issuing bank or are written off. The core capital ratio rises in both case, and the bank's financial situation stabilizes. However, the bond buyer doesn’t benefit at all. If they have acquired a CoCo bond that has been written off, they will simply have to accept a total loss of their investment. If it turns into equity, it becomes the bank's equity capital provider and probably must help shoulder some of the bank's losses.
The goal of this mechanism is to ensure that stumbling banks no longer require support from the government. But what happens if a bank buys another bank's CoCo bonds? Then the goal is jeopardized, because the bank that has purchased the CoCo bonds would need new capital in the event of a forced conversion and write-off of the bonds. If the bond is converted into equity capital, the bank suddenly owns a piece of another bank, and would be required to keep equity on hand for that.
Hence, the stability one bank gains is lost by the other. This is a zero-sum game, in the best of cases, because a contagion effect would also be likely. The original idea that the banking system would stabilize on its own with the help of CoCo bonds would implode. Therefore, in the interest of stability in the European banking system, investment banks should also be required to keep their hands off CoCo bonds.
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