Photo: Michael Kumm
Unbeknownst to many people, a relatively new debt instrument is being hotly debated behind closed doors by investors, policy makers and most importantly, by bankers.They are called Contingent Convertible (CoCo) Bonds.
Put simply, a CoCo bond is a security similar to a traditional convertible bond in that there is a strike price (conversion price). However they become convertible only when a specific event occurs.
Examples of such triggering ‘events’ are:
– If the share price exceeds a certain price (higher than the strike price)
– For banks the condition may be that it will convert to equity if the issuer’s tier one capital falls below a limit.
It is important to note that unlike a convertible bond, CoCo bonds don’t give the bondholder an option to convert to equity. The conversion is automatically triggered if the said ‘event’ takes place.
All the issuances of the CoCo bonds have been by banks so far. European banks have been frontrunners in this with U.K.’s Lloyds Banking Group PLC and Dutch cooperative Rabobank Nederlands leading the pack. Credit Suisse joined the group earlier this year. The Swiss Bank’s transaction involves US$ 2 billion 30-year non-call 5.5-year CoCo bonds priced at 7.875 %. The triggering events that shall cause conversion to shares are
• if the bank’s common equity Tier-1 capital falls below 7% of normal, or
• if the Swiss regulator determines Credit Suisse requires public-sector support to prevent it from going insolvent.
The issuance wasn’t much of a surprise to the market as Swiss banks were expected to come to with CoCos after their regulator set highly conservative bank-capital targets.
From the point of view of the bank that issues this security, this is attractive because it tops up the issuer’s capital automatically when the NPL (Non-Performing Loans) loans go up or there are derivative losses. Instead of the bank looking at the government for a bailout when it makes huge losses, it can bail itself out by getting a new injection of capital from conversion of the CoCos. And when the bank isn’t going through a rough time, it accounts for the CoCos as debt on its balance sheet, pays interest rate on them and consequently doesn’t dilute its earnings.
It is roughly estimated that over US$ 1 trillion of CoCo bonds shall be issued over the next few years as banks respond to new Basel III regulatory requirements on liquidity and capital adequacy.
NEXT WAVE OF CoCos: AMERICA
I expect the next surge in CoCo bonds to come from the U.S. where the banks have heavily relied on government bailout during the financial crisis of 2008. Of course there are important factors like regulatory approval, yields offered by CoCo bonds over US Treasuries, the first bank which decides to test the waters etc. to be considered before that happens. However it won’t be far-fetched to envision a realistic scenario in the near future when the Federal Reserve stops QE-II and banks can’t look towards the Government for life support anymore. CoCos can then be used for what I call ‘opportunistic capitalisation’ by these banks. In effect, CoCo bonds put the onus of bailing out banks that blow themselves up on its debt holders (of CoCo bonds) instead of the government. That is not such a bad way of preventing the tax payer’s money to be used to rescue irresponsible banks. Financial innovation meets public welfare, finally!!
CoCos IN ASIA
Banks in Asia didn’t get scathed as much as their American counterparts during the financial crisis. Consequently they didn’t require much government aid to ride the storm. However with Basel III norms which sets Tier 1 capital to 6 % starting 2015 they would be hard pressed to be sufficiently capitalised. At the same time, more clarity on Basel III regulations would still be needed, especially on where CoCos would fit in the capital structure to encourage Asian regulators to take definitive steps on them.
I am particularly interested in seeing how Chinese banks go about raising funds. Recently the China Banking Regulatory Commission has issued new regulations to bring the management of the country’s banking system in line with the Basel III requirements. The new rules will keep the minimum capital adequacy ratio at 11.5 % for big banks and 10.5 % for small banks. I won’t be surprised to see a flood of CoCo bonds by Chinese banks in 2012-2013 similar to that of high-yield bonds by Chinese real-estate companies in 2010-11.
CoCo bonds are a smart way of protecting tax payer’s hard earned money in case of a financial meltdown in the future. At the same time they shall aid banks in meeting the Basel III norms. I feel it is just a matter to time before a few banks, most of them American, start issuing CoCo bonds causing a domino effect of new issuances around the globe. Who knows, in an attempt to liberalize the RMB, China may introduce RMB-denominated CoCo bonds for its banks.
Just the way these bonds require a trigger to convert to equity, similarly this debt instrument needs a trigger itself to go viral. And I don’t think that the investors shall have to wait too long for that to happen. Watch this space.
(Tanuj Khosla is currently working as a Research Analyst at 3 Degrees Asset Management, a fund management firm in Singapore. He can be followed on Twitter @Tanuj_Khosla. Alternatively he can be reached at [email protected] Views expressed are personal.)
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