Wednesday, August 4, 2010

CoCo Bonds

Contingent convertible (CoCo) bonds are a new way for banks to raise capital. Traditionally, banks – like other businesses – had two sources of capital: debt (e.g. money from issuing bonds), which must be paid back to investors, and equity (e.g. money from issuing shares), which is permanent. In simple terms, this creates a conflict between the bank’s owners (who tend to prefer new finance to be raised from debt, to avoid having their own share of ownership reduced) and regulators (who expect banks to hold sufficient equity capital to cope with financial shocks). CoCo bonds are a kind of hybrid between debt and equity: they are issued as debt but convert automatically into equity when a bank gets into trouble.

What makes CoCo bonds so attractive?

Regulators and bankers are keen to avoid a repeat of the recent financial crisis, when existing forms of hybrid finance were shown to have serious failings. An inherent problem within banking finance is the risk of panic: when a bank needs to convert hybrid debt into equity, it sends a clear signal to investors that the bank is in trouble. These investors are then tempted to withdraw their investments, making the initial problem much worse. CoCo bonds are emerging as the most concrete new idea for solving these inherent problems, but many issues remain to be solved, not least how to define the trigger that causes the bonds to convert automatically.

CoCo bonds are debt instruments with the special feature that they will convert mandatorily in ordinary shares or similar instruments of the relevant issuer, mostly banks, when one or more triggers are met. Such a trigger could be for example reaching a certain threshold in the required capital ratio of the bank. In this aspect capital insurance bonds resemble more catastrophe bonds than convertible bonds. Hence they are also called Capital Insurance Bonds. However, as an emerging asset class there are still no clear market standards visible.

Holders of borrowed capital become regular stock holders, which increases the capital base of the institution. The investors are getting compensated for the risk of becoming a share holder at an unfavorable time through increased interest rates (in comparison to regular bonds).

The first CoCo bonds were issued by the partly government-owned Lloyds Banking Group in November 2009. If the capital ratio of Lloyds falls beneath 5%, the bonds (worth 10 bn Euro) will be swapped into shares. The Dutch Rabobank followed this example with the issuance of CoCo bonds in February 2010.

There is currently no further CoCo bonds issuance because the rating agencies are lacking confidence to evaluate the CoCo bonds due to the equity like character of the bonds. While the British Financial Services Authority (FSA) accepted those bonds as equity, the official announcement of the BASEL committee is still pending. The BASEL committee wants to declare in September 2010 if and in which form those CoCo bonds can be attributed to the equity of the financial institution. If that will be the case those bonds will most likely become extremely popular.