Was sind Contingent Convertibles (CoCos)?
Contingent Convertibles (CoCos) sinddebt instrumentmainly issued by European financial institutions. Contingent convertibles work in a similar way to conventional convertible bonds. You have a specificExercise pricewhich, once violated, can convert the title into equity or shares. The main investors in CoCos are private investors in Europe and Asia as well as private banks.
CoCos are high-yield, high-risk products popular with European investors. Another name for these investments is Enhanced Capital Note (ECN). Hybrid bonds include special options that support the issuance.financial institutionabsorb aCapital loss.
In the banking sector, their commitment contributes to strengtheningbalance sheetsIt allows it to convert its debt into shares when certain equity conditions are met. Contingent convertibles were created to help undercapitalized banks avoid another financial crisis like the 2007-2008 global financial crisis.
The use of CoCos has not been adopted in the US banking industry.Instead, US banks issue preferred stock.
Main Conclusions
- Contingent convertibles (CoCos) have an exercise price at which the bond is converted into shares.
- Contingent convertibles are used in the banking industry to support banks' Tier 1 balance sheets.
- A financially troubled bank does not have to repay the bond, make interest payments, or convert the bond into equity.
- Investors receive interest payments that are typically much higher than traditional bonds.
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Contingent Convertibles (Coco)
Understand contingent convertibles
There is a significant difference between contingent convertibles issued by banks and regular orplain vanillaconvertible bonds.convertible bondsHave the character of a bond, bear interest regularly and have priority over the underlying transactiondelinquentor fail to pay your debts. These bonds also allow the bondholder to convert the debt into common stock at a set exercise price, giving them an appreciation in share price. The strike price is a specific stock price level that must be triggered for the conversion to take place. Investors can benefit from convertible bonds because bonds can be converted into shares if the company's share price increases. The convertible assets allow investors to take advantage of the bond's fixed interest rate and potential for capital appreciation as share prices rise.
Contingent convertibles extend the concept of convertible bonds by modifying the conversion conditions. As with other debt securities, investors receive periodic fixed interest payments throughout the life of the security. Like convertible bonds, these subordinated debt obligations issued by banks contain specific triggers that detail the conversion of debt obligations into common stock. The trigger can take many forms, including the institution's underlying actions reaching a certain level, the bank's requirement to meet regulatory capital requirements, or the requirement of the administrative or supervisory authority.
Brief history of two CoCos
Contingent convertibles have become popular in the investment community to help financial institutions meet Basel III capital requirements.BaselIIIis a regulatory agreement that establishes a set of minimum standards for the banking industry. The aim was to improve supervision, risk management and the regulatory framework of the critical financial sector.
As part of the standards, a bank must have sufficient capital or cash to weather a financial crisis and absorb unexpected credit and investment losses. The Basel III framework tightened capital requirements and restricted the type of capital a bank can raise across its various tiers and capital structures.
One type of bank capital isTier 1 capital— the highest rated capital available to offset non-performing loans on the institution's balance sheet. Tier 1 capital includesretained earnings— an accrued income account — and common stock. Banks issue shares to investors to raise funds for their operations and to recover losses from bad debts.
Contingent convertibles act as additional Tier 1 capital, enabling European banks to comply with Basel III requirements. These convertible debt instruments allow a bank to absorb the loss incurred by underwriting bad loans or other financial sector stresses.
Banks and contingent convertibles
Banks use contingent convertibles differently than corporations that use convertible bonds. Banks have their own parameters that guarantee the conversion of the bond into shares. OTriggering Eventfor CoCos, this could be the value of the bank's Tier 1 capital, the judgment of the regulator, or the value of the bank's underlying shares. Also, a single CoCo can have multiple triggers.
Banks absorb financial losses through CoCo bonds. Instead of converting bonds into common stock based solely on stock price appreciation, investors in CoCos agree to raise capital in exchange for regular debt income when the bank's capital ratio falls below regulatory standards. However, the stock price may not go up, but go down. If the bank is in financial difficulties and needs capital, this is reflected in the value of its shares. As a result, a CoCo may result in investors converting their bonds into shares while the share price falls, exposing investors to downside risk.
Advantages of contingent convertibles for banks
Contingent Convertible Bonds are an ideal product for undercapitalized banks in markets around the world as they abuilt-in possibilitywhich allows banks to meet capital requirements while limiting capital distributions.
The issuing bank benefits from the CoCo by raising capital by issuing bonds. However, if the bank has written a lot of non-performing loans, it may fall under the Basel Tier I capital requirements. In this case, the CoCo provides that the bank does not have to pay periodic interest and can even write off the entire debt to meet Tier 1 requirements.
If the bank converts the CoCo into equity, it can remove the amount of the liability from its balance sheet. This accounting change allows the bank to underwrite additional loans.
Debt has no end date by which principal must be returned to investors. If the bank gets into financial difficulties, it can defer interest payments, force a conversion into equity or, in emergency situations, write off the debt to zero.
Benefits and Risks for Investors
Contingent convertibles have become increasingly popular due to their high returns in a world of safer, lower-return products. This growth brought more stability and capital inflows to the banks that issue them. Many investors buy in the hope that one day the bank will buy back the debt and until then reap the high returns along with the above-average risk.
Investors receive common shares at a conversion rate set by the bank. The financial institution may set the conversion price of the shares at the same value as when the debenture was issued, the market price at conversion, or any other price level desired. One disadvantage of exchanging shares is that the share price goes downdiluted, further reducing earnings per share.
Additionally, there is no guarantee that the CoCo will convert into equity or be fully redeemed, meaning the investor can hold the CoCo for years. Regulators that allow banks to issue CoCos want their banks to be well capitalized and can therefore make it quite difficult for investors to sell or liquidate a CoCo position. It can be difficult for investors to sell their position in CoCos if regulators do not allow the sale.
Advantages
European banks can raise Tier 1 capital by issuing CoCos.
If necessary, the bank can defer interest payments or reduce the debt to zero.
Investors receive periodic high-yield interest payments above most other bonds.
When a CoCo is triggered by a higher share price, investors receive a share appreciation.
In contrast
Investors bear the risk and have little control when bonds convert to stocks.
CoCos issued by banks that convert into shares will likely result in investors receiving shares if the share price falls.
It can be difficult for investors to sell their position in CoCos if regulators do not allow the sale.
Banks and companies issuing CoCos have to pay a higher interest rate than on conventional bonds.
Real example of a contingent convertible
As an example, suppose Deutsche Bank issued contingent convertible bonds with a core Tier 1 trigger rate instead of an exercise price. When Tier 1 capital falls below 5%, convertible bonds are automatically converted into equity and the bank improves its capital ratios by taking bond debt off its balance sheet.
An investor owns a $1,000 face value CoCo that pays 8% interest per year - the bondholder receives $80 per year. The stock is trading at $100 a share as the bank reports widespread loan losses. The bank's Tier 1 capital falls below the 5% mark, resulting in the CoCos being converted into shares.
Let's say the conversion rate allows the investor to get 25 shares of the bank if they invest $1,000 in CoCo. However, the stock has fallen from $100 to $40 in the past few weeks. The 25 shares are worth $1,000 at $40 per share, but the investor decides to hold onto the stock and the next day the price falls to $30 per share. The 25 shares are now worth $750 and the investor is down 25%.
It is important for investors holding CoCos to assess the risk of having to act quickly if the bond is converted. Otherwise, they may suffer significant losses. As mentioned earlier, when the CoCo trigger occurs, it may not be the ideal time to buy the stock.