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Europe, NEWSLETTER, technical analysis

Could CoCos trigger the next financial crisis?

CALOGERO NICOSIA (ABC Economics) reports.

abceconomics-news-nr4-0316

Since the introduction of Contingent Convertible bonds (CoCos), a form of hybrid assets, many financial practitioners around the world, particularly in the US and in Britain,  have publicly criticised a product which is believed to be too opaque in valuation and largely untested.

As many believe CoCos could trigger the next European financial market crisis, time has come for us to shed some light on the salient characteristics of this instrument.

What is a CoCo bond?

A CoCo bond is a debt instrument that converts into equity or writes down as soon as the banks gets into a high threating situation. The Conversion or the write down happens via a trigger mechanism which is defined in the contract. Typically the trigger starts when the common equity TIER-1 or 2 fall below certain limits.

Investors holding CoCos enjoy a really high coupon, far above a standard bond coupon; however, should the CoCo issuer, typically a financial institution, face a stress situation and should its balance sheet shrink and the trigger level be reached, the investor could experience a write down on the bond, or see the bond being converted into equity. In the latter case, the CoCos holder will become a shareholder; however, should this occur, there is a high probability that the share value will be very low with the investor recording unexpected losses.

Beauty and the Beast

Although Bloomberg labelled CoCos ‘a high-yield investment with a hand grenade attached’, it is worth noting that their original intent was to reinforce the European banking system.

Beyond the divergence in the opinion around CoCos’ ability to strengthen the resilience of the banking system, it remains the fact the CoCo market is fast- growing.

The demand for CoCos is largely due to (i) European banks rushing into new issuance of capital in order to meet regulatory requirement under Basel 3 and (ii) the quest for high yield returns in the current context of ultra-low interest rates.

Who is investing in CoCos?

CoCos are proving popular amongst the financial sector, and in particular within the banking sector. However, the widespread use of this instrument could pose systemic risks to the financial community as investors willing to hedge their investments would have to short the equity share of CoCos issuers.

 

 

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