Would you let someone pay you to build your dream home on a fault line? Ironically, that is what investors are doing who are building their financial future on CoCos, or contingent convertible bonds.
CoCos are a special type of bond issued primarily by European financial institutions, although Chinese banks are issuing them as well and their popularity is rapidly increasing.
CoCos are first and foremost bonds, which means the issuing bank is borrowing money from investors who buy CoCos. In exchange, investors receive interest payments and (hopefully) get their principal back eventually.
CoCos pay high interest rates, often in the range of 8% for European CoCos, and as high as 12% for Chinese CoCos. Investors—especially retirees—have been scrambling to find income-producing investments since 2009. To investors who need income, yields in the 8-12% range look like a godsend. Additionally, these CoCos are generally issued by large, well-known banks, making them look relatively safe to individual investors.
CoCos pay high interest because they are . If a bank that issued a CoCo is in serious financial distress, it may be able to:
· Suspend interest payments indefinitely, without ever needing to make up delinquent interest payments;
· Postpone return of principal;
· Convert the bonds to equity, just when the bank looks like it might be going under; or
· Reduce the amount of principal that needs to be paid back.
To sum it up, depending on the particular CoCo (and every CoCo is different), the issuing bank can stop paying interest keep your money. Talk about an economic earthquake!
CoCo bonds have a relatively recent origin story. After the global financial crisis, banking regulators increased the capital requirements for banks. In other words, banks are required to have more cash on hand than they used to so that they can survive an economic crash without going to governments for a bailout.
CoCos help banks meet this requirement (hammered out at Basel III). In the event of a crisis, triggers built into the CoCo let the bank stop making interest payments and keep investors’ money. During an economic earthquake, CoCos are designed to be the first financial instrument to go bust. If a bank were a car, CoCos would be the bumper, designed to crumple in an emergency to save the rest of the vehicle.
As dangerous as investing in CoCos is, investors are attracted by the high interest rate they pay. The amount of CoCos issued by banks has been going up by 30-40% a year for the last four years, and shows no signs of slowing down.
While CoCos are becoming more common, one 2013 study found that large institutional buyers like insurance companies are not buying CoCos. Instead, individual investors have been snapping them up. In other words, large financial institutions that can accurately weigh the risks of investing in CoCos have decided it’s not worth it. Perhaps investors should pay attention.
Even if “smart money” were buying CoCos, they are not a good fit for most individual investors, for several reasons:
· The market for CoCos is so new that there is wide variation between different CoCos. If you buy an unsecured corporate bond, you probably don’t need to read all of the fine print to understand what you’re getting. Not so with CoCos. The trigger mechanism that forces losses on investors varies from CoCo to CoCo, and the loss absorption mechanism (conversion to equity or a loss of principal) also varies. Before investing in CoCos, you really need to read and understand the reams of fine print that are part of the CoCo. That is something most investors do not have the time or expertise to do so.
· The market for CoCos is unrated. Ratings agencies like Moody’s and Standard & Poors will review and rate most bonds, but only rate a very small portion of the CoCo market. While ratings agencies are certainly not infallible (cue the flashback to the subprime lending crisis here), they do provide a quick way to measure the quality of bonds, but you won’t find ratings assistance in the world of CoCos.
The fact that CoCos are unrated also has significant implications for their liquidity, how easy it is to sell these bonds. Many financial institutions and bond funds are restricted in what they can buy to bonds that have a credit rating. With no rating, many CoCos cannot be purchased by many of the big players in bond markets.
· CoCos are untested. Having only been around for a few years, no one is sure how CoCos will actually do in an economic downturn. They are like a car bumper that has never been in an accident or a new way of constructing houses that has never been tested in an earthquake. If investors who hold CoCos feel that there is a significant risk that a bank will stop paying interest or write down the value of their bonds, these investors will rush to sell. But there may not be enough buyers.
Perhaps it is no surprise that, in the United Kingdom, British securities regulators have banned sales of CoCos to individual, retail investors. Unfortunately, there does not appear to be any such protection for investors in the United States. During the next financial earthquake, retirees who hold CoCos may be the first casualties.
If you have questions about investment losses, the securities litigation attorneys at Investor Defense Law LLP may be able to help, and offer free initial consultations.
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