Recently I heard some one on TV say that when a financial risk is regulated and controlled, it migrates to some other area and there are always investors who put their money into such risky assets because they are attracted by the disproportionate returns.
One such phenomenon is the Contingent Convertible Bond. Traditionally we had Convertible Bonds that paid fixed coupon rate and either at the end of the term it could be converted to equities at a pre-determined price. The advantage in this kind of an instrument is that the investor gets fixed income without the risk and is assured of return of principal and the option to convert to equity and sell at a higher price at end of term assuming the equity share prices of the issuer has gone up in value during that period.
The Contingent Convertible Bond (CoCo) is different in the sense that the trigger to convert to equity happens when the issuer’s equity crosses a level of distress. This is advantageous to the issuer because during tough times, they can stop paying coupon rates and also convert the bonds into equity and have a stronger balance sheet. Of course, if this happened, the CoCo Bond holder will suffer significantly.
Central banks have been focused on making the capital structure of banks resilient. The Basel III capital requirements make the CoCo an ideal tool for banks. The CoCo can be converted to equity by the issuer bank if its capital ratio falls below a pre-determined threshold. However, each issuer may have their own specific terms and an investor has to be vigilant to ensure that it matches their risk appetite or circumstances.
The average returns on CoCo were in the region of 7% and attracted a lot of high net worth individuals. Many of them soon found the risk factor a bit too high for their taste and retreated while specialist Asset Managers and institutional investors stepped into the enlarging CoCo market.
The unintended consequences of the CoCo is that if the issuing bank runs into trouble and its CoCo is converted to equity. Then, the CoCo investor may try to short the stock to recover their losses. This could lead to a sharp fall in the equity price of the issuer over and above the downward pressure of equity dilution due to CoCo conversion.
One assumes that those specialists at the helm of institutions that deal in CoCo know what they are doing. Chances are that the high yield would have helped percolate these assets into the portfolio of fund managers struggling to provide attractive returns. If that is the case then the holder of such mutual funds will be in for a surprise when triggers get activated. Buyer be ware!