Over the past year banks across Europe have been issuing various financial instruments in an effort to raise much needed capital to boost their financial health to comply with stricter new regulations. These have ranged from raising new equity, the best form of capital, to selling Contingent Convertible Bonds (Coco’s). Coco’s however appear to be gaining popularity as the preferred vehicle for raising capital for these banks and investors who previously shunned these instruments appear in recent times to be favouring them as they hunt for yields in an ongoing low interest rate environment and seemingly endless central bank stimulus around the globe. Barclays Bank issued a 10-year coco in November 2011 with a fixed coupon of 7.625% but the market value bond struggled to break above par until late April 2013 following a second 10-year coco issuance with a higher coupon of 7.75% and slightly different terms. Both of these bonds are now trading at a price in excess of 103 with the expectation for greater price appreciation. Even more recent, Banco Bilbao Vizcaya Argentaria (BBVASM) which is the second largest bank in Spain, issued $1.5Bn of a perpetual coco on May 1 at a coupon rate of 9%. The bonds which were sold at par have already appreciated in value trading at a price in excess of 102 and offering current yield above 8%. Other banks are also expected to issue cocos in the latter part of this year as investor appetite mounts.

Contingent convertible bonds contain features of both debt and equity. The bonds are typically issued for a fixed period (e.g. 10 years), offer periodic coupon payments over its fixed period and may be repaid by the issuer before its stated maturity date. The bonds however convert into equity shares, should financial conditions of the issuer bank deteriorate to the extent that its capital ratios, for instance, fall below certain minimum levels. Coco’s offer relatively higher returns to potential investors but bear substantially more risk despite having credit ratings which may be assigned investment grade status. The Barclay’s 7.625% coupon bond issued in November last year, for instance, has a credit rating of “BBB-” by Standards and Poor (S&P) but an investor will lose his entire principal without any recourse if conversion is triggered. In the case of this Barclay’s bond, conversion is triggered if the bank’s core tier 1 capital ratio falls below 7%. Contrastingly, the BBVASM coco is rated BB- by “Fitch” rating agency but will transform into equity shares if conversion is triggered, thereby giving an investor the opportunity to recover some of its principal investment.

Coco’s are primarily capital securities used by banks to strengthen their capital base and absorb future losses. They offer relatively higher returns to investors but bear substantially higher risks. Coco’s are not plain vanilla bonds and investors should not compare the yield on a Coco to yields offered on a plain vanilla bond which has fixed coupon payments to maturity with no conversion component. The primary risk to an investor is the probability of conversion and the attendant possibility of principal loss. As always investors should consult with their financial planner or advisor to determine whether this investment is suitable for you.

Eugene Stanley is Vice President, Fixed Income and Foreign Exchange Services at Sterling Asset Management Ltd. Sterling is a licensed dealer and provides financial and advisory services to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, please e-mail us at: info@sterlingasset.net.jm or visit our website at www.sterling.com.jm