Recovering from the shocks of the 2008 financial crisis, Lloyds Banking Group issued the first contingent convertible bonds, also known as coco bonds, in November 2011. Today, in the midst of Europe’s sovereign debt crisis, countries look favorably towards these coco bonds to reinforce their weak banks without incurring a large bill.
What is a Coco Bond?
Coco bonds automatically convert debt into equity when capital and reserves fall below a predetermined level. For example, Lloyds Bank’s coco bonds convert to equity when its core Tier 1 capital ratio, a regulators’ measure of a bank’s health, falls below 5%. Conversions of its coco bonds into shares would immediately bring its Tier 1 capital to over 6.5%, helping it to maintain an ideal solvency ratio, at least for a while.
Coco bonds are a variation of convertibles, which are a general category of bonds that holders can convert into stocks of the issuing company. Convertibles are hybrid securities, meaning that they include features of both equity and debt. Hybrid securities usually pay higher interest rates than regular securities, but in the event of a crisis, banks can suspend payments or delay repaying the original value of these securities. In the financial crisis of 2008, influential investors of hybrid bonds threatened to boycott banks that would use this mechanism to curb losses. Because banks feared these powerful investors and were wary of triggering a panic, they continued to make interest payments on these bonds. Regulators eventually required banks to enact the suspension of payments on these bonds. In an attempt to better maintain the power balance between investors and banks, coco bonds arose.
Are Cocos the Key?
The Spanish and Portuguese governments announced recently that they will seek to strengthen their banking systems through coco bonds. As European countries ridden with debt, both Spain and Portugal do not want to directly bail out banks in fear of further increasing their sovereign debt and endangering their credit ratings. As such, they seek to purchase coco bonds from their weak banks to provide funds to them as well as give them a capital buttress in the event of a crisis.