What the heck are CoCos and why are they spooking the markets so much?

It’s a hybrid issuance with debt and equity characteristics – it pays regular interest to the holder and features loss-absorbing capacity that is triggered in the event of a capital shortfall.

“This market exploded when banks started needing more capital than they could get through traditional equity alone, following the global financial crisis of 2008 and the Basel III regulations, which saw new capital ratio requirements introduced. Banks needed liability instruments that could be converted to equity as and when required, most specifically in the event of losses so that capital levels could be maintained,” explained Alberto Matellán, chief economist at MAPFRE Inversión.

CoCos are bonds that react to a trigger event, such as regulatory capital falling below a certain level, and automatically convert to equity. This means a bank holding these instruments as part of its liabilities can use them to boost its regulatory capital levels compared to what they would be in a debt-only scenario.

“This is attractive for banks because it’s a way to improve AT1 (regulatory) capital without giving up control, and they are relatively cheap too, as long as things are going well,” said Matellán.

CoCos are perpetual in nature, i.e., they have no maturity date, although the issuer is free to decide whether to pay the established remuneration or not, in which case they convert directly into shares when capital sinks below a certain threshold.

CoCos are very complex instruments: their value depends entirely on the probability of the occurrence of the contingency that triggers their conversion to shares and how much they would be worth subsequently, added the MAPFRE Inversión chief economist.

Investors should take note that they could lose their capital in either of two scenarios: if the bank in question is going through serious difficulties, or in the event of insolvency, dissolution or liquidation of the issuer. Capital losses could also arise from selling CoCos in the market at a price below what was originally paid.

As part of the agreement to rescue Credit Suisse, the 17.3 billion dollars (15.96 billion euros) invested in CoCos evaporated, while ordinary shareholders will receive one UBS share for every 22.48 Credit Suisse shares they hold.

This is out of the ordinary, given that, in the event of the issuer’s insolvency, CoCos holders would be paid ahead of ordinary shareholders. The same thing happened with the Banco Popular in Spain a few years ago, although on that occasion, shareholders were also wiped out.

Similar to the Banco Popular situation, we can probably expect a flood of claims for compensation; two law firms, Quinn Emanuel and Pallas Partners, have already announced they will represent the bondholders.

The nature of CoCos, coupled with their illiquidity, makes them a poor choice for retail investors, especially at this time, even though, as Matellán notes, they are not typically directed at them.

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