CoCo Nuts Have Been Hammered, but the Market Is Doing Just Fine

Anxiety over whether Deutsche Bank would suspend interest payments on its contingent convertible bonds, otherwise known as CoCos, fueled a February selloff in the $250 billion market – as well as in bank shares broadly.  While Deutsche Bank has insisted that it will have no difficulty making interest payments, yields on CoCo bonds remain well above their levels at the start of the year – as shown in the graphic above.

According to the Telegraph, “Europe’s banks fear the CoCo market is dead.” And the Financial Times says that “the sell-off . . . raise[s] question over its role as a key component of bank capital.”

Is the pessimism warranted? And why care about the CoCo market at all?

CoCo bonds were developed after the Lehman crisis to eliminate the need for future taxpayer-funded bank bailouts. Under so-called Basel III international regulations, banks must hold minimum core capital – as a buffer against insolvency – equivalent to 6 percent of their risk-weighted assets. This capital is predominantly equity, but European banks are permitted to meet around a quarter of the requirement through CoCos.  Though they are bonds, CoCos act like equity if the bank runs into trouble.  Contingent on specified trigger events, such as the ratio of equity capital to risk-weighted assets falling below a certain threshold, banks can suspend the payment of interest on CoCos, convert them into equity, or even write them off entirely.

So what have we learned about the CoCo market over the past few weeks?  Notably, yields on CoCos issued by banks with substantial capital buffers have increased by only a small amount. For CoCo bonds with the same trigger point, as shown in the left-hand inlaid graphic above, those issued by banks with higher capital levels have generally experienced smaller selloffs. This shows that investors haven’t uniformly re-priced the risks associated with CoCos, and that well capitalized banks will be able to issue them at only slightly higher rates than before.

Even for banks that have experienced large increases in their CoCo yields, the bonds remain a favorable tool to meet capital requirements. The annual interest rate paid on CoCos was, before the recent turmoil, around 40 to 75 percent of the cost of the alternative for meeting such requirements – raising equity.  Current yields on CoCos suggest that, for some banks, this cost has now risen to a level equal to or slightly above their cost of equity.  However, this is an upper bound: Banks’ interest payments on CoCos are tax deductible.  Given effective tax rates of around 20 to 40 percent, CoCos should remain an attractive source of financing.

In short, CoCos will generally be more expensive to issue now that investors have re-priced the risks involved.  But reports of the market’s demise are greatly exaggerated.  Investors are still willing to hold and trade the bonds: Despite the recent turbulence, liquidity in the market has barely declined.  And most banks will still find CoCos a cheaper source of regulatory capital than equity.