There have been two types of coco to date: those which convert into equity when a bank’s capital ratio falls below a pre-agreed trigger and those which are written off entirely.
It is the latter that are proving controversial - and increasingly popular.
“The bank doesn’t have to default to trigger these cocos…the point is they can push losses on to bondholders and provide capital while the bank is still a going concern,” says Jenna Barnard, co-manager of the retail fixed income fund at Henderson.
Such criticism has not deterred the banks, particularly as demand has been buoyed by wealthy Asians who can snap up cocos with borrowed money, bolstering their returns.
Year to date global coco issuance stands at $8.5bn from eight deals, a record number, according to figures from Dealogic, all from European banks. That compares with $7.8bn in European issuance from four deals for the whole of 2012.
Keith Skeoch, chief executive of UK life company Standard Life, describes wipeout cocos as “death-spiral bonds”. However, he says they have a role where “there is a desperate need, particularly in the banking sector, for the provision of loss absorbing capital”.
Barclays issued a $3bn death spiral coco last November and followed it up with another $1bn issue in April. They yielded 7.6 per cent and 7.7 per cent respectively.
Earlier this month Credit Suisse issued its own $2.5bn wipeout coco, which yielded 6.5 per cent, that followed a $1bn issue from Belgium’s KBC with an interest rate of 8 per cent.
The Swiss bank said similar issues would follow, not least as it seeks to lock in historically low interest rates and take advantage of investors’ hunger for relatively high-yielding instruments.
It is why even coco critics, such as Ms Barnard, admit the asset class “will become quite hard to ignore”.
Other banks are choosing to plot a middle path.
Société Générale is preparing what it refers to as a “write-down, write-up” hybrid bond in which investors would take losses if the bank’s tier one capital falls below 5.1 per cent. However, if the bank recovers, bondholders would begin to get their money back.
“It’s not exactly a coco but it has a writedown mechanism…if the trigger is reached only a proportion will be written down, depending on where the capital ratio of the bank stands,” says Stéphane Landon, Société Générale’s head of asset and liability management. “If the bank gets better this amount can be reinstated and so the bond can be reinstated.”
Société Générale hopes to raise at least $1bn from the bond’s issue.
In the US, a more restrictive definition of regulatory capital effectively prevents US banks from including cocos in their tier one buffers.
US regulators are said to have been scarred by their experience during the financial crisis with other types of hybrid bank instruments combining equity and debt characteristics. Many of these hybrid products failed to absorb bank losses during the financial crisis.
“For anything to be Tier 1 in the US it has to be considered debt for accounting purposes,” says Anna Pinedo, a partner at law firm Morrison and Foerster. “So it really eliminates the role for contingent capital, which is debt that converts into equity.”
On Wall Street, some bankers are still hoping that new regulatory proposals requiring US bank holding companies to hold more longer-term debt could pave the way for contingent capital issuance. Dan Tarullo, a governor at the Federal Reserve, has suggested that cocos hold promise, although he later warned that approving the instruments could lead to a slippery slope of increasingly diluted capital standards.
“There’s still some hope,” says Ms Pinedo. “The Fed has said they’re going to agree a long-term debt requirement on bank holding companies…Tarullo has always been a supporter of contingent capital. There were hints in a few of his speeches that possibly long-term debt requirement could be satisfied with contingent capital.”
But for now, many US bank chief financial officers continue to eye their European brethren enviously.
“What we’ve seen by way of coco issuance from the European banks is that there’s a market,” says Ms Pinedo. “Now our market for financial institution products is so limited...all the banks can issue is senior debt, subordinated debt and non-cumulative perpetual preferred, and that’s basically it.”
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