Coco goes Loco!
26-05-2016 | by Pieter Jan van Krevel |
The title of this article does not pertain to mademoiselle Coco Chanel losing her marbles, nor to a small, furry animal going berserk over its squeaky toy. In this case, it refers to the Contingent Convertible bond (‘Coco’): a financial instrument that lately seems to have fallen from grace with the investment crowd.
While contingent convertibles exist on other securities for some time now, since the last financial crisis they have become quite popular amongst banks that use them to prop up their core tier 1 capital[1]. Similar to the hybrids from an almost bygone era, Cocos are hybrid securities that allow banks to consider them as equity. Why? Because they will either convert into equity, or be written off, if tier 1 capital falls below a preset threshold.[2] Cocos are (thus) heavily subordinated and carry a commensurate yield.[3] Or at least so it appeared.
Why then is their reputation going south? A first hiccup in their rise to popularity was caused by the implementation of the Basel III regime, under which not all Cocos are eligible for inclusion in tier 1 capital. Cocos with clauses on regulatory changes allow early redemption in that event, and when Lloyds wanted to call USD 5bn worth of Cocos on this ground, (legal) hell broke loose. Recently the UK Court of Appeal announced it would consider the previous appellate ruling allowing early redemption. The jury is still out, so to say.
This is not the only clause that can spoil the investors’ party. Common others are the issuer’s right to (indefinitely) skip interest payments, or postpone redemption. The latter can be as simple as just not call a callable perpetual, and thus ‘convert’ a Coco previously priced to first call in, say, 5 years, into an ‘real’ perpetual. Imagine what that does for NPV…!
Coco’s popularity took another hit last February, when rising concerns about Deutsche Bank’s performance – and even viability – triggered speculation about DB having to skip coupon payments on its Cocos, caused by some rather obscure accounting idiosyncrasy. Chaos quickly spread to other Cocos, bank stocks and bonds alike.
UBS‘ March 14 issuance of a new USD 1.5bn Coco proves things have quieted down somewhat, but investors have become more aware of both the complexity and the risks Cocos bear. It seems that the market is realizing that, as ever, there is no such thing as a free lunch. Not even a meagre loaf of coco bread.
[1] First Coco issued in November 2009 by Lloyds Banking Group, with Rabobank following suit in March 2010.
[2] Some, qualifying, Cocos are also referred to as ‘AT1’ – Additional Tier 1. These are considered the riskiest debt issued by banks.
[3] The 2010 Rabobank issue was e.g. priced at 300bps over a similar but non-convertible loan.
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