INVESTING EXPLAINED: What you need to know about contingent convertibles or CoCos, securities that are a mix of a bond and a stock
In this series, we break down the jargon and explain a popular investment term or theme. Here’s CoCos.
Some kind of cereal?
CoCos is an abbreviation for contingent convertibles. These securities – which are a mix of a bond and a stock – were conceived in the aftermath of the global financial crisis.
The aim was to provide a buffer for banks’ finances, thereby limiting the possibility of future government bailouts, for which taxpayers foot the bill. CoCos can be converted into shares of the bank if capital falls below certain levels.
Which banks issue them?
Those in the UK and the rest of Europe, including BNP Paribas, Barclays, HSBC, Lloyds, NatWest, Santander and UBS. American banks usually don’t.
Who invests in them?
The CoCos market has grown so much that it was valued earlier this year at $275 billion, most of which is held by financial institutions that love high yields. These institutions viewed CoCos as risky, but not overly so, although recent events have led them to reassess this view.
Safeguard: CoCos – which are a mix of a bond and an equity – were conceived in the aftermath of the global financial crisis
And these events are?
Serious doubts have been raised about the value of CoCos following the takeover of the collapsed Credit Suisse by UBS, another Swiss banking giant.
Finma, the Swiss financial watchdog, has ordered that the $17 billion of AT1 bonds issued by Credit Suisse be written down to zero as part of the acquisition.
Credit Suisse shareholders — usually ranked below bondholders in such situations — will receive some cash, $3.23 billion.
But holders of CoCo bonds get nothing. The fine print of these particular bonds would have allowed for a total write-off, although the holders were apparently unaware of this. They are now planning legal action against Finma.
What has been the reaction?
The Bank of England and European regulators say they would follow the usual hierarchy if a bank failed, with shareholders, rather than bondholders, bearing the brunt of the losses.
Nevertheless, the wipeout of Credit Suisse bonds has raised the alarm, with bond prices from other banks in the same category falling sharply.
Their yield has doubled (when the price of a bond falls, the yield rises).
The fallout has spread to banking stocks. Standard Chartered chief executive Bill Winters said the move has “profound” implications for how banks are regulated.
Do CoCos have a future?
Experts have called the CoCos market a “busted flush.”
In a letter to the Financial Times, Theo Vermaelen, a finance professor at Insead business school, wrote that while CoCos were intended to keep a bank alive, they were “tools to facilitate a well-structured funeral ‘.
What happens now?
This is a moment of fear for banks. The collapse of Credit Suisse followed the bankruptcy of US Silicon Valley Bank. In the US, the concern has shifted to First Republic Bank and in Europe to Deutsche Bank. Against this background, banks may find it more expensive to raise capital, which would affect their profitability. They may also be more limited in their lending.