A spokesperson for Eiopa says the authority will keep a watch on additional Tier I capital instruments issued by banks and "monitor the developments related to these instruments and assess their impact on financial stability and consumer protection". This comes after Gabriel Bernardino, chairman of Eiopa, referenced Cocos as an area that would be receiving attention from the authority in a July 17 speech to the 11th Handelsblatt annual conference on Solvency II in Munich.

Bob Haken, partner at Norton Rose Fulbright in London, says: "This is a warning shot to the industry: ‘Don't think that just because this acts like a debt security we're not going to subject it to scrutiny.'"

Coco bonds are debt instruments that are written down or converted into equity when the issuing bank's regulatory capital levels breach a predefined trigger, typically close to the point where the bank can no longer function as a going concern. They are classified as additional Tier I capital instruments under Basel III, and regulators in Europe have been keen to promote their issuance thanks to the bonds' loss-absorbing capacity.

From the investor perspective, Cocos offer the upside of senior debt (long tenors and predictable cashflows) with a little extra risk (that the trigger is breached), which translates into higher yields. Christoph Hittmair, London-based global head of the fixed-income group, debt capital markets at HSBC Investment Bank, explains that Cocos typically yield 400–500 basis points above above the mid-swaps rate (the average of bid and ask swap rates, comparable to Libor), compared with senior debt, which typically yields within 100bp. This makes them an attractive investment in the current low-yield environment.

Hittmair believes Eiopa's concerns are more focused on the interconnectedness resulting from insurers investing in bank debt rather than the Coco instruments themselves. Investors need to demonstrate that they understand the risks they are taking on, he says.

 

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