DURING the financial crisis, Western governments poured hundreds of billions of dollars into their banks to avert collapse. The search for ways to avoid future bail-outs started before the turmoil ended. One of the niftiest proposals was the “contingent convertible” (coco) bond, which turns into equity when the ratio of a bank’s equity to risk-weighted assets falls below a predetermined danger point (since set at a minimum of 5.125% for cocos, although it can be up to around 7%). The ambition was grand. As the Squam Lake Group, composed of mostly American academics, put it in 2009, the automatic conversion of cocos would “transform an undercapitalised or insolvent bank into a well-capitalised bank at no cost to taxpayers”.
At first, regulators were keen. In 2010 Mervyn King, then the governor of the Bank of England, said he wanted contingent capital to be a “major part of the liability structure of the banking system”. Swiss regulators, too, pushed for coco issuance. The hybrid nature of cocos seemed a way to satisfy both regulators, who wanted banks to have bigger safety buffers, and bankers, who were reluctant to issue new shares because of the high cost of capital. The hope was that investors, too, might see the appeal of an asset that offered a higher yield than bank bonds but lower risk than bank shares.
Nine years after the first cocos were issued by Lloyds Banking Group in Britain, they have not fulfilled this promise. To be sure, they are now an established asset class, with around $155bn of issuance in 2017 in dollars, euros and pounds. But this is a fraction of more than $1trn in bank debt issued that year. Cocos are issued by only around 50 banks in a dozen countries, mostly in Europe (American banks, barred from issuing cocos by regulatory and tax constraints, instead use preferred equity, an established asset class with similar traits). Although cocos are held by the world’s largest asset managers, including BlackRock and PIMCO, few specialise in them. Exceptions include niche funds run by Algebris Investment and Old Mutual Global Investors (OMGI).
The main reason is that, despite early enthusiasm, regulators did not throw their weight behind cocos. In 2011 the Financial Stability Board, a global grouping of regulators, decided that they would not count towards the capital “surcharge” the biggest banks would be required to hold. Only equity would do. Rules on “total loss absorption capacity” finalised in 2015 require banks to have liabilities that can take a haircut or be wiped out if they are liquidated or restructured. But a wide range of liabilities, from shares to subordinated and even senior debt, is included. Cocos became part of a spectrum of at-risk liabilities, rather than a neat, catch-all solution.
The result is that cocos are a specialised investment proposition. They still offer fairly high yields—currently 5.3% for dollar cocos and 3% for those in euros, according to indices compiled by Credit Suisse, a bank. And they offer a premium over junior debt. They have appealing technical characteristics, too. Unlike bonds with a fixed maturity, they are perpetual, but redeemable after five years. If not redeemed, their coupon resets with reference to the mid-swap rate, a widely used rate related to interbank lending rates (so a bond issued at 8% when the swap rate was 2% would reset to 11% if rates rose to 5%). That offers some protection against inflation. In 2016 investor jitters caused a spike in coco yields. But since then, nerves have calmed and spreads have narrowed (see chart).
But the idea that cocos would help struggling banks recapitalise seems far-fetched. Without a regulatory requirement to issue lots of them, the banks that are least likely to need them are the ones best able to find buyers. Rob James, who co-manages the coco fund at OMGI, emphasises the importance of looking at the strength of banks, and rules out investing in “stressed” ones. For investors already exposed to distressed banks, it generally makes sense either to buy equity—and lots of it—to recapitalise the bank, or to lend to it in the form of safer senior debt.
Last June Banco Popular, a Spanish bank, was forced into a restructuring and sale under the European Union’s new bank-resolution framework. It was a test for both cocos and the regulator. The bank had already had trouble selling cocos, demonstrating investors’ lack of interest in the asset class. In the restructuring, cocos were wiped out, alongside junior bondholders and shareholders. (At least coco investors in the stricken bank could console themselves that they had been paid an 11.5% coupon. Junior debt investors got just 5%, even right at the end.)
Coco bonds’ technical characteristics, and their premium over other forms of junior debt, mean that they will remain an attractive niche investment. But this is quite a comedown for an asset class once touted as an elegant, almost automatic, way to return struggling banks to health.