Europe’s coco bonds risk turning into coco pops

March 13, 2014 6:00 am

Europe’s coco bonds risk turning into coco pops

By Ralph Atkins

Danger of safety valves turning into poor deal for investors

Beware financial innovation – this was an important lesson of the global financial crisis. Regulators and investors have become wise to “financial market engineering” – the dreaming up by bankers of new ways of apparently spreading risks.

Sometimes, as with the packaging up and reselling of US “subprime” mortgages, the learning process was brutal. Of course, the global financial system is now immeasurably safer as a result of all the new rules, checks and balances, isn’t it? But what if regulators are complicit in financial innovation?

That is the case with this year’s market novelty: “coco” bonds. Rapidly gaining in popularity, these are securities confected by banks to strengthen their finances that act like conventional bonds – unless the bank gets into trouble. Then they either convert into shares or are simply wiped out.

They are called “coco” bonds not because of their sugary coating – although investors receive a relatively generous interest rate to compensate for the risks they are taking – but because they are “contingent convertible” capital.

Death spirals

Coco bonds have won approval from regulators on both sides of the Atlantic as a way for banks to build potential loss-absorbing financial cushions – and thus provide an alternative to taxpayers footing the bill when the next crisis strikes.

European issuance exceeded $14.3bn last year and is close to $10bn already this year, according to Dealogic.

Despite the broad regulatory approval, however, this has so far been almost exclusively a European phenomenon, with no issuance in the US. Spain’s Santander and Denmark’s Danske Bank issued cocos last week. Other big name issuers have included Barclays, Credit Suisse and UBS.

In a low interest rate environment, cocos are a cheaper way for banks to raise capital than issuing equity, and allow them to tap different investors. What could possibly go wrong?

It does not help confidence that cocos are already referred to as “death spiral bonds” by some investors. This is because of fears that – rather than acting as safety valves – their effect will be to accelerate the downward plunge in a bank’s share price when trouble strikes.

If cocos are bought by arbitrageurs, they will hedge against the risk of them being forced into becoming equity holders by shorting the bank’s stock – selling shares to buy them back at a lower price.

Then, if the bank’s capital falls through the trigger threshold and cocos are converted into equity, the holdings of existing shareholders are diluted, adding to the downward pressure on share prices, which would already be falling precipitously.

I am reassured that the latest variations of coco bonds include mechanisms to prevent such “death spiral” effects. They are also less problematic when coco bonds do not convert into equity but are simply wiped out. Even then, however, there may be hidden dangers with cocos.

Perverse incentives

A new research paper – not yet published but updating earlier work – by Tobias Berg and Christoph Kaserer, economics professors at Bonn University and the Technical University of Munich, argues cocos create “perverse incentives” – which is a polite way of saying they may in fact make banks more reckless.

One scenario would be if a bank was heading into a danger zone with its capital ratios falling towards levels that would trigger the wiping out of cocos. Rather than taking preventive action, the bank’s shareholders – who have control over its managers – would actually have an incentive in letting the situation worsen.

This is because shareholders’ losses would then be shared with coco bondholders but they would benefit from any subsequent turnround. For similar reasons, coco issuing banks have less incentive to increase capital pre-emptively when trouble looms.

At best, coco bondholders could end up getting a poor deal. The value of their asset is likely to vary wildly according to the bank’s fortunes: they gain nothing when the bank does well but suffer big losses when things go wrong.

Then there is uncertainty over when exactly cocos would be triggered by regulators. As products created in the wake of the financial crisis, cocos have not yet been tested in adverse circumstances.

How much should we worry? Without a track record, it is hard to judge whether cocos are correctly priced. Buyers so far have been professional investors presumably able to make sensible judgments.

Cocos also account for only a small proportion of bank debt issuance. In Europe last year, they accounted for just 4 per cent of the total. But volumes are increasing exponentially.

Let’s hope coco bonds don’t turn into coco pops.