Contingent Convertible Bonds

Do you remember the mid-1990’s film Speed? It was not a complex plot: a bus would blow up if its speed dropped below 50mph and Sandra Bullock had to keep driving it very fast or else all the passengers would die. Good. You are already half way to understanding Contingent Convertible Bonds, or CoCo’s.

The analogy is not quite perfect, so instead imagine that Ms Bullock had to drive very slowly on the motorway, downhill with a following wind. If she ever reached as fast as 50mph then it would all go Pete Tong. That is a CoCo.

Contingent Convertible Bonds are also known as Enhanced Capital Notes. The latter, however, have no connotations of chocolately breakfast cereals and are thus only referred to by regulators and analysts. Their popularity (or notoriety) originates from the Great Financial Crisis, when everyone decided it was rather unfair that taxpayers should have to pay to rescue dastardly banks whilst bond holders were laughing, as they say, all the way to the bank.

Everyone agreed that we needed something new. Something that was not quite a bond, not quite equity, but yet which save us all from having to rescue another reckless bad bank. Let’s ignore the bizarre fallacy that equates anything a government does to ‘tax payers’ money’ and focus on the CoCo. This is a bond that will convert to equity if a pre-determined event comes about. Some form of ‘moral hazard’ for bondholders.

This pre-determined event is known as the ‘trigger’. This is most commonly something bad happening to the issuer. In the UK, experience of CoCo’s typically extends as far as Lloyds Bank; here the trigger is Lloyds Tier 1 Capital Ratio (we may tackle bank capital ratios in a further Jargon Buster, but bear with us for now) falling to 5%. Banking regulators have deemed than 5% is not enough; should this happen the bank will need less debt and more equity and the CoCo’s will automatically convert into equity.

That seems a pretty rough deal. The CoCo converts into equity when the bank is in crisis. When things are at their worst, your bond suddenly becomes equity. Whoops. Who in their right mind would want one of those? Lots of people, is the answer, because to compensate for this risk of explosion, CoCo’s pay eye-wateringly high coupons. The headline rate of interest on Lloyds’ CoCo’s goes up to 16.125%, for example. Does this not look like very reasonable compensation for backing Antonio Horta-Osorio’s ability to keep the bus at the right speed?

Not according to the FCA, who imposed a moratorium in August 2014 on sales of these ‘risky and highly complex’ investments to retail investors. CoCo’s come with acres of small print and more weasel words than a husting in the Wild Wood. It turns out the FCA was warning against itself, or specifically the Prudential Regulatory Authority. Tucked away in the small print was the right for Lloyds to redeem a number of its CoCo’s should they be excluded from a regulatory stress test. Which they now have been and outraged bondholders have called in the lawyers. It is not just a bank crisis that can cause CoCo’s to implode, it is a bank boom.

CoCo’s are top shelf products, for consenting adults only. An investor’s quest for yield should never take them into territory they not only do not but actually cannot understand.

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