During the 2008 financial crisis, numerous banks faced capital strains. Many governments have stepped in to restore the banking sector with taxpayers’ dollars. As a result, many new regulations were published and imposed to improve the resilience of the banking sector, particularly for the strengthening of banks’ capital base.
As a result of the higher capital requirement from new regulations, e.g. Basel III standard, a new type of convertible bond instrument became popular among banks — the contingent convertible bond, which is also known as CoCo.
CoCo is a hybrid form of financing instrument, containing features of both debt and equity. It has fixed remuneration feature like typical debt, together with a loss absorbing capacity of an equity. It is usually issued by banks as a subordinated bond which pays a coupon, and it can be either converted into common equity or written down when certain contractually specified events occur. Such triggering events are commonly designed against banks’ regulatory capital ratio.
A traditional convertible bond is converted to common shares in the event that the underlying share price appreciates beyond a pre-determined threshold level, upon investors exercising their rights. In contrast, for CoCo bond, it is automatically converted into common equity or written down when the bank’s capital ratio falls below a pre-set level. With this mechanism, the issuing bank capital level can be boosted up to meet the regulatory requirement. Due to the abovementioned mechanism, CoCo is considered a relatively risky security, and usually comes with an attractive yield of around 5%-7% p.a.
As of 2014, issuance levels reached close to $170 billion globally.
Based on news articles, at the beginning of 2016, the market started to questioned Deutsche Bank’s ability to meet its coupon payments. In less than 2-months’ time, the price of Deutsche Bank’s CoCo bond had slumped by 70%, and panic spread to other European banks’CoCo bonds as well. Since then, European regulators have clarified their regulation approach to CoCo bond coupon repayment, effectively reducing the uncertainty on banks’ coupon payment, which helped to fuel a recovery in the CoCo market later in the year.
As of June 2017, the total outstanding volume of CoCo bonds have grown to around $675 billion worldwide, with China becoming the biggest source of issuance.
- CoCo bonds usually offer investors with high coupon payment, commensurate with high inherent risk. Upon the occurrence of a trigger event, the bond will be converted to common equity, leaving investor with no payment of coupon and potential capital loss.
- The market performance of CoCo bonds is highly related to market liquidity and well-being of the overall banking industry. Historically there have been turmoil events that caused substantial fluctuations in the CoCo bond market.
- The value of CoCo bond is positively correlated with stock price, and has relatively weak correlation with bond index and gold price.
- CoCo bond has the same priority claim as junior subordinate debt upon insolvency liquidation. CoCo bond investors have higher priority claim than preferred shares, but lower priority claim than senior debt.