Has the CoCo bubble popped?
It’s proven hard to avoid hearing about CoCos over the past few weeks during the stock market turmoil. Along with a potential Brexit, they have been one of the primary reasons for the market downturn experienced by the majority of the banking industry.
The question on everybody’s lips is: ‘What are CoCos and why are they having such a direct impact on share price?’
Contingent convertible capital instruments (CoCos) are hybrid debt instruments that absorb losses when the capital of the issuing bank falls to a pre-specified level. They were created on the back of the Financial Crisis in 2008 with the aim of preventing the tax payer from having to bail out banks during periods of stress. CoCos have two primary characteristics which differentiate them from other debt instruments:
1. They possess the ability to absorb losses by generating capital when specific criteria are met
2. A trigger is defined which activates the capital generation described above
The trigger is the specified point at which the loss absorption technique is activated. There are two types of trigger which are used by banks:
- Specified triggers relate to the loss absorption solution being imposed when the capital of the issuing bank falls to a specified level or percentage of its risk weighted assets. These triggers can either be priced at book or market value
- Discretionary triggers allow regulators to impose the loss absorption, if they feel that the bank’s solvency is called into question. Very specific conditions are usually detailed in the prospectus around when regulators can exercise this trigger
The loss absorption technique refers to what happens once the trigger is met:
- Equity conversion is the usual loss absorption technique used by CoCos. When the trigger is met then the underlying bonds are converted into equity with the outcome being increased capital within periods of stress
- A principal write-down (full or partial) can also be used
CoCos are having a significant impact on the banking environment as investors are concerned that the issuers may not be able to meet their coupon payments over the coming years. If this was the case then the triggers would be met and the CoCos would be converted into equity. This concern has led to three major impacts upon banking products:
- Stock prices have fallen under the belief that banks won’t be able to make their coupon payments on CoCos
- The price of CoCos have fallen whilst yields have increased (An example 6% CoCo in EUR rose to more than 13% yield up from 7.5% at the start of January)
- Investors are searching for instruments they can use to hedge their CoCos. There is currently no CDS market aimed at CoCos which has led investors to use credit indices and equity put options to hedge their positions
But are these price falls justified or has the run on CoCos simply snowballed out of control? The problem is the ownership profile of these bonds. They are the riskiest debt issued by banks and this is demonstrated by the 6-7% coupon rate associated with them. Less than a quarter of the Eurozone market was judged as investment grade last year which should have kept unsophisticated investors away from investing. However, the high coupon rate coupled with the belief that banks would never be in a position where they would need to exercise the conversion option led naïve investors to believe that these bonds were effectively providing free money. Thus many of these products have found themselves in the hand of unsophisticated investors (largely wealthy clients of private banks) rather than the more savvy institutional investors.
The recent price crash is partly due to the fear that banks will default on their coupon payments but also due to the fact that some of the bonds are in unstable hands. In a market with limited liquidity and a diverse investor profile then the result is the price crash which has been witnessed.