Contingent Convertible Bonds (CoCos) are convertible bonds issued by banks. Like

Question

Contingent Convertible Bonds (CoCos) are convertible bonds issued by banks. Like all convertible bonds, CoCos generate a yield and have a strike price at which the bonds are convertible to company stock. Unlike a normal convertible, a CoCo only converts to a company’s stock when its capital ratio trigger is hit, which is explained below. It’s also important to 1 note the relative margin of safety a CoCo investment provides as compared to its associated stock, which is based on its superior position in the capital structure. Based on the article posted along with this assignment, please answer the following questions in your own words: (1) How are CoCos different from traditional convertible bonds, and why are they attractive to investors? (2) What are the major benefits to have banks issues CoCos? Please list at least two.

Explanation / Answer

1.How are CoCos different from traditional convertible bonds, and why are they attractive to investors?

The difference between CoCos and their traditional counterparts is related to the conversion process; traditional convertible bonds provide the holder with the option to convert if/when the bond hits its conversion strike price, while CoCos will not convert to equity until its issuing bank's capital ratio falls below a specified level, at which time the bank is forced to convert the bonds to equity. The conversion level is typically based on a percentage of the bank's tier one capital. If the bank's ratio falls below its trigger point, the debt is converted into common stock, while the bank is then no longer required to pay its stock dividends.

(2) What are the major benefits to have banks issues CoCos? Please list at least two.

i) In the context of crisis management, contingent convertible bonds have been particularly acknowledged for their potential to prevent systematic collapse of important financial institutions. If the conversion occurs promptly, a bankruptcy can be entirely prevented due to quick injection of capital which would be impossible to be obtained otherwise, either because of the market or the so-called recapitalization gridlock.

ii) Due to its debt nature, a contingent convertible bond constitutes a tax shield before conversion. Hence, as compared to common equity, the cost of capital and, consequently, the cost of maintaining a risk absorbing facility are lower.

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