Why ‘coco’ bonds may not be as sweet for investors as once thought

Concerns have been raised about the risks of investing in ‘coco’ bonds (contingent convertible bonds). Many private investors may not have been made fully aware of the serious risks that these types of bonds involve.

Over the last three years, a new form of financial security has emerged in response to regulators’ demands that banks position themselves to better absorb losses during a crisis (rather than expect the taxpayer to bail them out). Known variously as bail-in bonds, hybrid bonds, wipe-out bonds and contingent convertible bonds, trades in these securities have reached €75bn (£60bn) on European markets and are predicted to reach €100bn by the year’s end.

As European banks prepare themselves for the impending stress testing of Basel III, coco bonds have provided a cheap means of improving the banks’ tier-one capital ratios. Banks are required to hold a proportion of their risk-weighted assets in the form of tier-one capital (comprising common equity and retained earnings) so that losses will fall on shareholders rather than creditors. Coco bonds, costing roughly half the return on equity demanded by shareholders with the benefit of tax-deductible interest, appear to be a win-win for both banks and regulators…

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