CoCo Bonds – Debt/Equity Hybrid Finance

Contingent convertible bonds or “CoCo” bonds are one of the newest assets classes to hit financial markets. Their purpose is to clear up uncertainties surrounding hybrid bonds.

The biggest problem with existing hybrid bonds was deciding when the bond went from debt to equity.  Initially being considered debt, hybrid bonds allow the borrowing institution to obtain liquidity without decreasing the stock price through new issuance. However, in the event of financial distress the bond would convert to equity to sure up the capital requirements of the lending institution.  This would sure up the balance sheet of the lending institution and provide confidence to their investors/depositors.  But deciding when/if this conversion would take place was apparently debatable and caused major issues in the financial markets during the recent financial crisis.

Essentially, hybrid debt allows lender to be highly leveraged in good times but appear highly capitalized in bad times.  What the new CoCo bonds do is provide a pre-specified trigger regarding when exactly the bond changes from debt to equity. This relieves the uncertainty previously plaguing this asset class.

Issuance of CoCo bonds has increased from $2 billion in 2010 to over $20 billion in 2014 (year-to-date). This is partly do to regulators seeing this type of bond as an answer to the capital issues that lenders face during times of financial distress. Also, Scott Mather, manager of Pimco’s Total Return Fund, recently stated that he saw opportunities in CoCo bonds and believed they were “cheap”.

So what is the downside? Personally, I see a potential problem in directly linking debt finance to equity finance.  If these bonds become wildly popular, then stock prices could become inflated through high levels of debt issuance.  But in the event of a crisis, the debt would convert to equity and drive stock prices down very quickly.  The potential volatility seems immense so tempering the issuance of these bonds should be an essential piece of macroprudential regulation.

References:

Reuters Article w/ Scott Mather

Financial Times Youtube Video w/ Philippe Bordereau

featured image provided by reuters.com

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