Here's what coco bonds are and why investors are freaking out about them

After a rally on Wednesday, banking stocks are falling hard again on Thursday.

Deutsche Bank is down over 3% in Frankfurt, Credit Suisse is down over 6% in Switzerland, and in London HSBC is down over 4%, Lloyds is down over 4%, Barclays is down over 5%, and Royal Bank of Scotland is down over 4%.

It means bank stocks have reverted to the trend of the year so far: falling.

This week’s latest sell-off has been driven by a scare over so-called coco bonds that were issued in the wake of the 2008 financial crisis by banks and haven’t been thought of too much since.

Here’s a handy explainer as to what’s actually going on.

What are Coco bonds?

Coco bonds are a type of debt with strings attached. The coco in the name is short for “contingent convertible,” which means in some circumstances the debt converts into equity — rather than the bank owing you money, you suddenly own a little bit of the bank.

The “contingent” part of the bonds depends on how much cash the banks have. If a bank’s capital falls below a certain level the switch is flipped and the bonds turn into shares. Because of this risk, coco bonds carry a higher yield than normal bank bonds.

Coco bonds were cooked up in the wake of the financial crisis as a way to prevent banks needing any more state bailouts. If banks were getting into trouble and running low on cash, the bonds would convert, solving two problems — the bank’s debt burden lessens and boosts capital buffers.

Lloyds is the biggest coco bond issuer in the UK, with $14.5 billion (£10.7 billion) of the paper issued between 2009 and 2015, according to Moody’s.

Why are people worried?

Put simply, investors are worried they’re not going to get their money back.

There are growing fears that banks like Deutsche Bank and Santander aren’t going to be able to meet coupon payments — interest on the debt.

The Independent writes:

A recent move by the European Central Bank to publish an obscure test of bank risk, known as the Srep ratio, has driven the recent upset in the market. The results have stoked fears in the minds of credit analysts about whether recent market shocks — ranging from low oil prices to the slowdown in China — could inadvertently cause banks to breach rules which would prompt regulators to stop them paying Coco coupons.

These same capital breaches could also turn the coco bonds into equity, which is falling in price and not something fixed income investors want.

As a result of these growing fears the price of coco bonds have plummeted in recent weeks. Meanwhile the price of credit default swaps — a sort of insurance that pays out if banks don’t pay up on the bonds — has jumped.

Banks, meanwhile, have been defending their balance sheets and insisting everything is OK. Deutsche Bank’s CEO John Cryan says the lender is “absolutely rock solid” while Credit Suisse’s boss Tidjane Thiam has also been talking up his bank’s balance sheet.

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