Contingent convertible bonds (“CoCos”) have been in the news lately. And not in a good way. As several European banks have reported poor earnings recently, investors have become concerned again about banks. Cocos have been ground zero for those fears.
Banks have issued CoCos over the past few years to meet Additional Tier 1 and Tier 2 capital requirements under Basel III. The CoCos of a number of big European banks have been in virtual freefall in recent weeks, with some falling to as low as 70 cents on the dollar after trading above par in 2015. From what we hear, this is all happening with limited liquidity as there are apparently few buyers of these bonds.
Two years ago, in our blog “CoCos: An Overview of the Anti-Convertible Bond,” we explained why we were avoiding CoCos:
In many ways, a CoCo is the mirror image of a convertible bond. Instead of the equity upside participation and potential downside protection that can make a convertible bond so attractive, CoCos may have much higher potential downside. … CoCos typically pay higher coupons than a bank's straight bonds. However, if the bank gets in trouble (think 2008), these bonds turn into equities …
In our convertible portfolios, we're focused on upside equity participation with potential downside protection over full market cycles. Because the risk/reward profile of these bank CoCos is the opposite of the risk/reward profile we look for in convertible bonds, we are quite willing to pass them by.
Now that a whiff of fear is in the air, apparently many holders of these bonds are beginning to understand our concerns. (You can read the full blog here.)