The article “Regulators must act on coco bond risks” published in Financial Times emphasized on the trending and complex instrument “coco” in today’s financial world. What exactly are those coco bonds?
Contingent Convertible bonds (CoCo) are hybrid subordinated bonds which entails both debt and equity features. CoCo are classified as ordinary liabilities for accounting purposes and are intended to be automatically converted into common equity or written down on a pre-specified trigger event. CoCo are intended to automatically stabilize bank balance sheet in bad times when raising new capital is difficult and hence to reduce systemic risk.
CoCo are characterized by two key features – the conversion trigger and the conversion mechanism. The trigger specifies conditions that trigger the conversion mechanism of CoCo and the conversion mechanism specifies what happens with CoCo upon a trigger event. The conversion to equity could be in the form of fixed number of shares or variable number of shares. The nominal value of bond could be written off either completely, partially, permanently or temporarily.
The tax-deductible coupon payments and lower cost of capital compared to other sources of raising capital make coco much attractive to banks. The high interest rate on coco compared to other types of bonds and in low interest rate environment make coco much attractive to investors too.
CoCo are exposed to three types of risk such as interest rate risk, conversion risk and equity risk.
CoCo bond market grew rapidly and currently yielding around 7%. Banks are expected to come up with more new issues of CoCo to replace conventional subordinated bonds as a part of regulatory capital.