CO-COS: THE BASICS

Q.What are “co-cos”?
A.“Contingent convertible bonds”, are bonds that turn into equity at a given trigger-point, for example, if a bank’s capital ratio falls below regulatory requirements, or if an institution has to be taken over by the state.

Q.Why are they suddenly so popular?
A.Co-cos have not traditionally been popular because issuers must pay a premium to get investors to take on the risk that their bonds might turn into equity. But the Basel III capital rules impose stringent new requirements on banks for holding enough “loss-absorbing” capital. A release on 13 January clarified that co-cos can count towards this requirement, prompting more banks to consider issuing them to meet the rules.

Q.Why do regulators like them?
A.Regulators view them as a way to align bondholders’ incentives with regulators’. The aim is to encourage banks’ bondholders to keep an eye on risk-taking, rather than simply assuming they will be bailed out by the state if the bank fails. Owners of co-cos have every incentive to make sure that their bank’s capital ratio does not fall too low, or else their interest-paying bond will turn into non-interest-paying equity.

Q.What about alternatives, like “bail-in” bonds?
A.Bail-in bonds are similar to co-cos in that they can turn into equity, but the key difference is that the regulator decides when this conversion is triggered. This uncertainty could make them very difficult to price.