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CoCo bonds were created after the crisis to prevent bailouts
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Value of bank CoCos are falling amid concern about payments
Deutsche Bank AG’s
attempts
to reassure investors about its ability to pay its debts have shone a
spotlight on a type of security that didn’t exist as recently as three
years ago. Here’s what you need to know about CoCo bonds. For more
background, check out our QuickTake.
QuickTake Contingent Convertibles
Deutsche
Bank may struggle to pay coupons to investors in its Additional Tier 1
securities, also known as CoCos, in 2017, analysts at CreditSights Inc.
wrote Monday. This helped trigger a sell-off in the bank’s shares and
bonds, while the cost to insure against a default on its debts climbed.
The bank issued a statement saying it had plenty of capacity to make the
interest payments.
What is a CoCo bond?
A contingent
convertible capital instrument, or CoCo, is a type of bond designed by
regulators after the financial crisis. The bonds allow banks to skip
interest payments without defaulting, and they’re designed to convert to
common equity or suffer a principal writedown if a bank runs into
trouble. This provides a buffer in times of stress while inflicting
losses on CoCo investors.
So how does it work?
CoCos
typically allow a bank to stop interest payments when it runs into
trouble, like when its capital ratios breach levels considered dangerous
(that’s the “contingent” part). If the bank’s financial health
deteriorates further, CoCos can force losses on bondholders. The bonds
can lose their value entirely or change into common stock (that’s the
“convertible” part).
How do banks determine whether they can pay?
This
is where it gets really technical. To make optional payments such as
dividends, bonuses and coupons on CoCos, banks must calculate their
“available distributable items," or ADIs. Deutsche Bank, which has to
make the calculation based on its audited, unconsolidated accounts under
German GAAP, has thinner coverage than other major banks, prompting the
current volatility.
Why did regulators create CoCos?
During
the financial crisis, taxpayers had to inject billions of dollars into
failing banks, while investors in those lenders’ bonds were often fully
repaid. Officials wanted to create ways to avoid this in the future.
What’s the issue now?
The
market is only three years old and the securities are untested.
Investors have three concerns given banks’ weak earnings and market
volatility: that lenders will have to halt coupon payments, that they
won’t buy back the securities as soon as hoped, and most of all that
there will be a loss of principal.
What’s the fallout at Deutsche Bank?
The bank’s 1.75 billion euros ($1.98 billion) of
CoCos fell to a record low of 70 cents on Tuesday versus 93 cents at the start of the year. Its senior
bonds
have fallen as low as 89 cents, while its shares have almost halved
this year. Credit default swaps that pay out if Deutsche Bank defaults
on its subordinate debts have more than doubled so far in 2016.
How about other CoCos? What’s going on with them?
Banks
have issued about 91 billion euros of CoCos since April 2013. Investors
piled into them last year, searching for yield, and were rewarded with
returns of about 8 percent. Those gains have been all but wiped out in
less than six weeks this year. Deutsche Bank isn’t alone; UniCredit
SpA’s 1 billion euros of 6.75 percent bonds dropped to a record-low 72
cents after the Italian lender reported a decline in quarterly profit.
Bonds issued by Barclays Plc, Lloyds Banking Group Plc and Royal Bank of
Scotland Group Plc also fell.
Is there a broader risk?
The
current volatility could damp investors’ appetite for CoCo bonds the
next time lenders try to issue them, and a sell-off might bleed into the
wider credit markets.
