They are called COCOs
(contingent convertible bonds) and are debt instruments issued by European financial
institutions. They work similar to convertible bonds with a specific strike price
that once breached, the bond can be converted to stock or equity. Investors of
COCOs are individual investors in Europe and private banks. COCOs are high
yield, high risk in European investing.
In the banking industry
their use helps support the bank’s balance sheets by allowing them to convert
the debt to stock when specific capital conditions require. They were created
to prevent another financial crisis similar to that of 2007 – 2008 and help
undercapitalized banks.
In contrast, the US
banking industry prohibits to use COCOs, instead they issue preferred stock.
Investors can benefit from convertible bonds since the bond can be converted to
stock when the stock price is appreciated. The convertible features allows
investors to have a fixed interest rate, and the capital appreciation from a
rising stock price. Then receive fixed periodic interest payments on the life
of the bond.
COCOs first made their
appearance in 2014 to help financial institutions meet the BASEL III capital
requirements (providing minimum standards for the banking industry). As part of
those standards, a bank must maintain sufficient capital to be ab le to absorb
a financial crisis and unexpected losses from bad investments or loans.
One type of capital is
Tier 1 capital (the highest rated) to offset bad loans on the bank’s balance
sheet. Tier1 includes retained earnings as well as shares of common stock. COCOs act as additional Tier 1 capital.
Instead of converting bonds to commons shares based on the stock price
appreciation, COCOs investors agree to receive equity in exchange for the
regular income received from the debt when the bank’s capital ratio falls below
regulatory standards.
If a bank is having financial
difficulty and is in need of capital this is reflected in the value of the
shares. COCOs have an embedded option. An embedded option is a feature of a
financial security (a bond in this case) that allows holders take specific
actions against the other party. An embedded option gives the investor (call
provision) the power to redeem the bond before its scheduled maturity. In the
case of convertible bonds, they would have the right to exchange the bond for
shares in the underlying stock. The banks that issued the COCOs benefits by
raising capital from the bond issue.
However, if the bank has
underwritten many bad loans (as in the case of Greek banks) they may fall below
Tier 1 capital requirements. The stipulation carried by the COCOs states that
the bank is not required to pay periodic interest payments, or may even write
down the full debt to satisfy Tier 1.
When a bank converts
COCOs to shares, they may move the value of the debt from the liability side of
the balance sheet. This trial balance change allows the bank to underwrite additional
loans.
Bill T. Alexandratos
October 2020
