Coco bond susceptible to systemic risk

on Jul 12, 2012 in Fixed Income, Home | 2,754 comments

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Put simply, a coco bond is a security similar to a traditional convertible bond and becomes convertible only when a specific event occurs, rather than being simply convertible at the option of the bondholder.

For banks, the triggering event may be that it will convert to equity if the issuer’s tier one capital falls below a limit. The conversion will then re-capitalise the bank. In this aspect coco bonds resemble more catastrophe bonds than convertible bonds.

Credit Suisse priced the first contingent capital in February last year. The Credit Suisse bonds convert into equity if the bank’s common equity tier one ratio falls below 7%.

The main purpose of coco bonds is to increase a bank’s capital in times of distress. If the trigger is never met, coco bonds are considered as debt instruments which are included in bank’s core capital.

Thus, instead of the bank looking at the government for a bailout, it can bail itself out by getting a new injection of capital from conversion of the cocos. Coco bonds are a smart way of protecting tax payers in case of a financial meltdown. At the same time they shall aid banks in meeting the Basel 3 requirements.

However, let’s assume that a bank decides to issue half of its capital via a coco bond. If the bank runs into trouble, those bonds would convert into equity, diluting existing shareholders. The share capital of the bank would now be equally split between the former bondholders and shareholders. In such a scenario, conversion of the bond would lead to a halving of value of the share price. This would wipe out existing shareholders of 50% of their wealth.

Bottom line: a coco bond creates a barrier effect, in other words, a drop in equity value at the trigger level. This is what caused me to question the real benefit of the instrument. But another implication of this barrier effect is that any new coco issue has an impact on the position of existing coco holders and shareholders, as it could trigger further drop in equity value. But investors and regulators alike have voiced concerns that these bonds, by design, convert into equity at a time when the bank’s share price is likely to already be under pressure.

The presence of such a convertible in the capital structure may create a self-fulfilling death spiral. Investors concern about potential dilution as well as bank’s health may generate panic selling.

To conclude, such products would definitely not replace the need for banks to raise permanent capital.