Ralph Atkins: Questions surround Europe's coco bonds

13 March 2014

Writing for the FT, Atkins says that coco bonds accounted for just 4 per cent of bank debt issuance in Europe last year. But volumes are increasing exponentially and with it there may be hidden dangers.

Coco bonds have won approval from regulators on both sides of the Atlantic as a way for banks to build potential loss-absorbing financial cushions – and thus provide an alternative to taxpayers footing the bill when the next crisis strikes. European issuance exceeded $14.3 billion last year and is close to $10 billion already this year, according to Dealogic. Despite the broad regulatory approval, however, this has so far been almost exclusively a European phenomenon, with no issuance in the US. 

It does not help confidence that cocos are already referred to as “death spiral bonds” by some investors. This is because of fears that – rather than acting as safety valves – their effect will be to accelerate the downward plunge in a bank’s share price when trouble strikes.

Atkins says he is reassured that the latest variations of coco bonds include mechanisms to prevent such “death spiral” effects. They are also less problematic when coco bonds do not convert into equity but are simply wiped out. Even then, however, there may be hidden dangers with cocos.

A new research paper – not yet published but updating earlier work – by Tobias Berg and Christoph Kaserer, economics professors at Bonn University and the Technical University of Munich, argues cocos create “perverse incentives” – which is a polite way of saying they may in fact make banks more reckless.

At best, coco bondholders could end up getting a poor deal. The value of their asset is likely to vary wildly according to the bank’s fortunes: they gain nothing when the bank does well but suffer big losses when things go wrong. Then there is uncertainty over when exactly cocos would be triggered by regulators. As products created in the wake of the financial crisis, cocos have not yet been tested in adverse circumstances.

Cocos also account for only a small proportion of bank debt issuance. In Europe last year, they accounted for just 4 per cent of the total. But volumes are increasing exponentially. Let’s hope coco bonds don’t turn into coco pops.

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