CoCo, Contingent convertible capital instruments are the hybrid debt instruments that absorb the losses of the issuing bank when the capital of the bank falls below certain level. These instruments have come into existence since 2009, after the financial crisis.
Though banks have issues closed to $70 bn worth of CoCos, still a lot less than issued subordinate or senior unsecured debt in same time period.
The main features of CoCo instruments are how they absorb losses and what are the triggers for them.CoCo absorb losses either by getting converted into equity or by write downs. Triggers can be based on mechanical rules or these can be supervisors’ discretion. In the former case, the loss absorption mechanism is activated when the capital of the CoCo-issuing bank falls below a pre-specified fraction of its risk-weighted assets. The capital measure, in turn, can be based on book values or market values.
Discretionary triggers, or point of non-viability (PONV) triggers, are activated based on supervisors’ judgment about the issuing bank’s solvency prospects. In particular, supervisors can activate the loss absorption mechanism if they believe that such action is necessary to prevent the issuing bank’s insolvency.
As per BCBS guidelines, CoCo can be part of the tier 1 capital if minimum trigger level for the instrument is 5.125%. Lower triggered CoCos can be part of the tier 2 capital.
The yields on CoCos are consistent with their place in the bank’s capital structure. CoCos are subordinated to other debt instruments as they incur losses first. Accordingly, the average CoCo yield to maturity (YTM) at issuance tends to be greater than that of other debt instruments (eg other subordinated debt and senior unsecured debt). The YTM of newly issued CoCos is on average 2.8% higher than that of non-CoCo subordinated debt and 4.7% higher than that of senior unsecured debt of the same issuer.
Though banks have issues closed to $70 bn worth of CoCos, still a lot less than issued subordinate or senior unsecured debt in same time period.
The main features of CoCo instruments are how they absorb losses and what are the triggers for them.CoCo absorb losses either by getting converted into equity or by write downs. Triggers can be based on mechanical rules or these can be supervisors’ discretion. In the former case, the loss absorption mechanism is activated when the capital of the CoCo-issuing bank falls below a pre-specified fraction of its risk-weighted assets. The capital measure, in turn, can be based on book values or market values.
Discretionary triggers, or point of non-viability (PONV) triggers, are activated based on supervisors’ judgment about the issuing bank’s solvency prospects. In particular, supervisors can activate the loss absorption mechanism if they believe that such action is necessary to prevent the issuing bank’s insolvency.
As per BCBS guidelines, CoCo can be part of the tier 1 capital if minimum trigger level for the instrument is 5.125%. Lower triggered CoCos can be part of the tier 2 capital.
As discussed in FT, CoCo instruments are highly complex and they can behave as death spiral risk (losses accelerates as things gets worse). In normal markets these instruments behave as HY bond but in distress markets they expose investors to equity like risk and volatility. Currently Both banks and regulators are smiling at the success of bail-in bonds. For regulators, cocos help to plug the capital gap of European banks. For bankers preparing for the upcoming European Central Bank stress tests, cocos are a cheap way to boost capital: they cost roughly half the return on equity demanded by shareholders, and interest is tax-deductible. It seems like a win-win.
The yields on CoCos are consistent with their place in the bank’s capital structure. CoCos are subordinated to other debt instruments as they incur losses first. Accordingly, the average CoCo yield to maturity (YTM) at issuance tends to be greater than that of other debt instruments (eg other subordinated debt and senior unsecured debt). The YTM of newly issued CoCos is on average 2.8% higher than that of non-CoCo subordinated debt and 4.7% higher than that of senior unsecured debt of the same issuer.
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