IN recent times, banks across the world have been issuing new types of financial instruments. This trend is part of an effort to increase the size of their capital base which will in turn improve their financial health and bring them into conformity with changing regulations.

These securities are part of a new asset class that provide investors with a different method of achieving higher risk-adjusted returns.

These instruments vary in their structure and risk profile. Investors must understand clearly the terms and conditions associated with each security. These instruments span the low end of the bank’s capital structure ie between equity and subordinated debt.

One particular instrument — contingent convertible notes — has features of both debt and equity. The securities offer periodic coupon payments over a fixed period and may be repaid by the issuer before its stated maturity date. However, the issuer also reserves the right to convert the securities into equity (ie shares) or even suspend, write down or cancel principal payments to the holder. This condition can only be triggered if financial conditions of the issuer bank deteriorate to the extent that its capital ratios (or other pre-established thresholds) fall below certain minimum levels.

Bank COCOs offer relatively higher returns than plain vanilla bonds issued by the same entity.

For example, Barclays Bank issued a 10-year COCO in November 2011 with a fixed coupon rate of 7.625 per cent. The market value of the security struggled to break above par until late April 2013 following a second 10-year COCO issuance with a higher coupon rate of 7.75 per cent and slightly different terms. Both of these securities are now trading at a price in excess of $111.00 each.

Similarly, Banco Bilbao Vizcaya Argentaria (BBVASM), which is the second largest bank in Spain, issued US$1.5 billion of a perpetual COCO in May 2013 at a coupon rate of nine per cent and the securities are currently trading above $108.00.

Ongoing global central bank accommodation continues to push yields lower (even negative in parts of Europe) and therefore augurs well for the ongoing favourable performances of these instruments. The capital gains in addition to the attractive coupon rates appeal greatly to investors.

Naturally, investors bear substantially more risk because of the contingent nature of the securities.

Some COCO securities even have credit ratings which may be assigned investment grade status. The HSBC 6.375 per cent 2049 issued in September 2014, for instance, has a credit rating of “BBB” by Fitch ratings agency, but an investor can lose his entire principal without any recourse if conversion is triggered. In the case of this security, conversion is triggered if the bank’s core tier 1 capital ratio falls below 5.125 per cent.

Contrastingly, the BBVASM COCO is rated BB- by Fitch rating agency and will transform into equity shares if conversion is triggered, thereby giving an investor the opportunity to recover some of his principal investment.

Investors must look carefully at the relative value of each security.

COCOs 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.

COCOs 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.

Who knows, you may end up being in love with the COCO.

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

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