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Not a Sweet Fix

May 2016

As the hunt for yield grows, investors are warming up to a new type of debt instrument – CoCo bonds. But why cocos aren’t as secure as other debts issued by banks?

While financial product innovation has been held responsible as the core of the Great Recession, the aftermath has continued to witness bankers experiment with innovation as regulators attempt to decipher ways to curtail the playing ground. One of the direct fallouts of this play has been the emergence of the Contingent Convertible bonds, also known as Additional Tier 1 Capital (AT1 bonds) or most simply referred to as CoCo Bonds.

Taking-Stock-1In essence, Cocos emerged from regulators across the globe developing stringent norms aims at strengthening the banks’ balance sheet with a focus on building equity. This as industry participants have described, ‘makes bail-outs less likely and, if they prove inevitable, less painful for taxpayers’. These bonds typically allow banks to stop coupon payments in times of trouble and can in times of distress force losses on bondholders, losing their value entirely or changing into common stock. Cocos, thus, emerge as the hybrid of bank equity and debt.

While their roots can be traced back to late 2009, in the midst of the financial crisis, with Lloyds issuing Enhanced Capital Notes (ECNs) paying annual interests upto 16%, majority of issuances have happened in the last 3 years, since 2013. Credit Suisse, Royal Bank of Scotland, Deutsche Bank AG, Societe Generale have been amongst the banks issuing AT1 bonds aimed at bulking up their capital buffers. The month of March saw UBS Group AG sell $1.5 billion of CoCo Bonds, which was met with a strong investor response triggering the final interest rate set at 6.875% against the earlier indicated 7% to 7.125%. However, after a watershed year in 2014, global issuance volume of Contingent Capital securities for 2015 fell sharply by 42% YoY to $101 bn. Moody Ratings in a recent report highlighted the primary reason for this dip being the lower issuance by Chinese banks driven by persistently weak market conditions.

Taking-Stock-2From an investor perspective, CoCos find their natural positioning within the high-yield debt allocation. While yields remain the most attractive feature of this segment, investors would be well-advised to factor in the higher degree of sensitivity this category of bonds shares with macro-economic news and events. As has now been well established, the year began amidst serious concerns threatening the global economy. Risks including the drop in oil, leading the overall commodity pack and a slowdown in the Chinese economy, threatening global consumption, aggravated concerns of a direct fallout on the banking sector, raising fears amongst many of banks getting pushed to the brink, leading to their halting Coco coupon payments. One of the major impacts of this was seen on Deutsche Bank AG which has seen a significant fall in its issued coco bond price.

As the financial infrastructure globally undergoes an overhaul in the post-2008 era, this hybrid instrument, which is increasingly garnering eyeballs across the globe is bound to be scrutinized in the effectiveness of its role as a shock absorber, which was the basis of their creation. Amidst the same, the echo of ‘CoCos remaining untested’ is bound to resonate amongst market watchers, with there being no case registered of an event triggering the conversion from bonds to shares.

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