The current banking crisis has affected a wide range of firms, including some of the largest on the planet. And in the turmoil, some formally ‘good as gold’ assets are now looking pretty shaky. That includes more than $250 billion worth of bonds issued by European banks.
While many investors may not be familiar with Contingent Convertibles or CoCo bonds, the asset type has formed the backbone of capital ratios for the European banking sector since the Great Recession. With recent moves and emergency buyout deals, the validity of these bonds is now in question.
For investors, the wipe-out of CoCo bonds brings forth a variety of questions and concerns about their holdings and whether or not other bank debt could be at risk.
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CoCos in a Nutshell
The ghosts of the Great Recession seem to be here again with the current banking and liquidity crisis. So, it’s pretty ironic that a security used to shore up finances during that tumultous period could be in danger. The security in question is CoCo bonds.
Like today, liquidity and capital ratios were a huge issue during the Great Recession. European banks were particularly hard hit. With regulators requiring strong Tier 1 or AT1 ratios—or excess reserves to be placed on the books to create a safety buffer—the banks took to issuing CoCos as a way to meet requirements.
CoCo bonds are very similar to any other convertible bond you can purchase. They feature bond-like characteristics, including paying a regular rate of interest. The difference is that CoCo bonds become equity due to various ‘triggers’ rather than simply passing a strike-price and having the resulting firm making the conversion. The triggers are such that if the bank gets into trouble or needs more funding, it can do so by removing debt—turning its CoCos in equity—and adding additional bonds to boost to capital ratios.
And because of the equity kicker, many regulators and analysts didn’t necessarily consider CoCos as ‘debt’ on a balance sheet.
UBS & Credit Suisse Throw Cold Water on CoCo Market
The CoCo market worked well for the last decade or so, until the current banking malaise. Swiss bank Credit Suisse has had its share of troubles lately and those issues finally compounded to the point the bank had to be rescued by Swiss banking authorities and rival UBS.
In that rescue package, Swiss authorities agreed to wipe out and writedown to zero 16 billion francs, or about $17.3 billion worth of Credit Suisse’s additional tier 1 CoCo bonds.
The issue is, when it comes to the bankruptcy pecking order, bondholders are normally senior to equity. Shareholders are paid last after various bondholders are given their share of the remaining assets. With the CoCo wipe-out, regulators have decided to reverse that pecking order. Credit Suisse equity holders were given shares in UBS for their troubles. That’s a huge issue considering European banks have about $250 billion in CoCo bonds outstanding, not to mention other debts.
Naturally, bond investors did not like the news. While there are no CoCo-focused funds here in America, two European ETFs— Invesco AT1 Capital Bond UCITS ETF and WisdomTree AT1 Coco Bond UCITS ETF —both fell by 6% and 9%, respectively. Many individual CoCo bonds—such as those issued by HSBC —fell by nearly double digits. All in all, the sector is trading for pennies on the dollar.
Big Ramifications
It may be easy to pass off the CoCo bond wipe-out as an isolated incident or only affecting Europe. But it may have some big ramifications for all bondholders and investors, not just those in CoCo bonds.
For starters, it shows that bonds’ safety in the capital stack isn’t a guarantee. Clearly, regulators are willing to throw standards out the window when a crisis is here and unprecedented events take place. American banks don’t issue CoCos, but they do issue other debt and preferred shares. And we did just see regulators back deposits above FDIC limits for failed banks at home. Given the ripple effects, bondholders may start demanding higher coupon rates to compensate for newfound confusion and potential passing over when crisis hits.
Second, banks across the board could be affected. For one thing, they may find it hard to raise capital going forward to boost reserve ratios. This could hit dividends and buyback programs as more of that capital is forced to go toward reserves. Additionally, the banks may be forced to reduce exposure to ‘risky’ assets, lending activities, and other segments. This could hinder profitability and share prices, exacerbating the effect.
All in all, the ripples from the CoCo wipe-out could be a bigger deal than we expect.
Something to Think About
Fixed income investing is prized for its stability and safety, particularly in distress. With the UBS buyout of Credit Suisse and the wipe-out of its CoCo bonds, the pecking order of bonds and equity has been turned on its head. For investors, the ripples of the action could be far reaching.
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