Recent market volatility concerned not only equity investors, but there are also signs that the bond market, especially high-yield fixed income market, is facing some headwind. With a bear market on the horizon and maybe a global economic slowdown, one particular asset class requires some extra attention of ours --- Coco bonds.
Coco bond is the shorthand of contingent convertible capital securities, also known as additional Tier 1 notes. It is a bail-in capital that has the automatic loss absorption feature that either converts into common equity or triggers a principal write-down before, or at the point of, the issuing bank’s insolvency.
Coco became popular among banks in Europe and Emerging market after the 2008 financial crisis, as they can be used to satisfy the capital adequacy requirement of the Basel III. Coco, given they fulfill specific design structure requirement, can either be Additional Tier 1 capital or Tier II capital of the bank.
While Coco bonds are the type of markets that mostly participated by institutional investors like hedge funds and banks, Coco has an increased presence in different investment markets. Last December, Marketwatch reports that certain mutual funds have exposure to Cocos; in June, we saw a Coco ETF entered the market.
Still, it is reaching to say that retail investors are exposed to Coco at this stage. However, the Coco market has not gone through a down cycle ever, and no one can be sure of the effect of broad adoption of Coco on the financial market when the next crisis hit. It is essential to have some understanding of the recent Coco market developments and be better prepared for the coming downturn.
Concentration in EU and EM banks
The first thing to keep in mind is US banks' issuance in the Coco market is almost non-existent. The first region to adopt Coco is the advanced European countries, issuers headquartered in the UK and Switzerland were particularly active. The pie chart below is as of 2013:
Since then, emerging markets had become particularly active issuers of Cocos. China has even become the largest issuer of Coco as of 2015:
While Coco has not been adopted in the US, the US dollar is still one of the most common denomination currencies, just behind RMB as of 2015. Euro-denominated Coco is also quite common.
All in all, the basic idea is that banks tend to either issue CoCos in their respective home currency, or in US dollars.
Under-capitalized bank reluctant to use Coco
According to this BIS working paper, contrary to our wishful thinking, an under-capitalized bank normally has less incentive to use Cocos to strength the banks' capital adequacy.
The researchers suggest there is an inverted U-shaped relationship between the bank's incentive to issue Coco and the bank's equity capitalization. Assuming that shareholder interest is the only consideration in the banks' decision making when the bank is under-capitalized, shareholders won't benefit much from Coco issuance as most benefit goes to senior unsecured debt holders.
On the other hand, if the bank's equity capitalization is high, Coco, alongside with common stock, would be considered as expensive capital that is not necessary. So, it is only when the banks have an intermediate level of capital would have the incentive to offer Coco, as this seems to benefit both the shareholders and debt holders. Hence the inverse U-sharp relationship.
In their empirical test, the researchers found support to the model. According to their regression result, a higher Tier 1 capital ratio is associated with a later issuance date of the first Coco; more specifically, a one-percentage-point increase in Tier 1 capital, including CET1 and AT1 is associated with a 3.8-month shortening in the time to issuance, out of a sample average of 55.7 months (from January 2009) for all issuers.
However, given there was not enough data on highly-capitalized banks, they can't successfully test whether extremely adequate capital level would also delay the first Coco issuance.
Is Coco "good news" for bank's share price?
The same BIS paper's model also has some implications on the effect of Coco to issuer bank's riskiness and share value.
First of all, no matter what the design is, a Coco issuance should reduce the risk of the issuers' senior unsecured debt, as Coco would increase the recovery value of the debt in case of default. The empirical finding supports the suggestion that Coco issuance is correlated with a fall in the price of Credit Default Swap of the bank's existing debts.
Nonetheless, the effect of Coco issuance on the bank's stock price is far from clear. In theory, it whether Coco issuance is good news to the shareholders depends on whether the bank has a strong balance sheet. If it has, Coco issuance is bad news as it would be considered as expensive, yet unnecessary, capital that reduces shareholders' return. Meanwhile, if the bank's balance sheet is weak, then Coco issuance should be considered as good news, as it can share the loss shareholders is facing.
The empirical finding suggests that only when the issuance is for a Coco with principle write down as the loss absorption mechanism and at the same time with a high conversion trigger (i.e., easier to reach the trigger), then the share price will have a positive response. In the other cases, the effect of Coco issuance on stock price is not significant.
So the lesson for investors is simple --- don't expect Coco issuance is good for the stock performance.
Coco crisis can be contagious.
In a recent research paper, three Bank of Italy economists look into the 2016 Coco bond market turbulence. They tried to identify the Coco-specific contagion channel of the yield volatility in the Coco market.
Their results show strong evidence about the existence of a CoCo-specific contagion channel in the distress propagation, which supports the claim that these instruments might be a source of financial instability when adverse shocks occur.
Also, they found that the behavior of the CoCo issued by riskier banks does not significantly differ from that of CoCo issued by safer institutions. Hence, there is evidence that Coco instability can be contagious and might threaten the overall financial stability.
However, readers should also keep in mind that last year Spanish lender Banco Popular, collapsed and was acquired by rival Spanish bank Santander for €1. Popular’s equity and CoCo bondholders lost everything. In this case, there was no sign of pan-market panic.
So, while Coco crisis can be contagious, we still don't know when it will be the case and when it will not. Further research and real-world data points are needed before research can draw a definite conclusion.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.