In exchange for accepting such risks, investors should be remunerated in the form of a high fixed coupon. However, given the numerous regulatory capital requirements it is highly challenging for retail investors in particular to assess how likely it is that the issuing bank will require capital later on, and whether or not the coupon in fact appropriately compensates for this risk.

Those investors who lack a profound understanding of the financial sector, the functioning of the bonds and, above all, banks' regulatory own funds requirements, therefore should not invest in CoCo bonds. It is very difficult to estimate the inherent risks, particularly for retail investors. This article provides an overview of some of the key risks of investing in CoCo bonds. However, it does not constitute an exhaustive list.

At a glance: CoCo bonds

Simply put, CoCo bonds are perpetual, generally fixed-coupon debt securities which are either converted into equity – usually shares – or be permanently or temporarily written down upon the occurrence of certain trigger events stipulated in the terms and conditions of issue.

On conversion, investors turn from creditors into shareholders or equity providers without being able to prevent that. A trigger event usually involves an issuer's capital ratio falling below a specified threshold. As a consequence, the CoCo bonds are converted or written down when the issuer requires capital.

Although CoCo bonds are currently attracting increasing attention from the print and online media, the term in and of itself is not new. It has long been used to describe debt securities which may be converted, contingent on the occurrence of certain conditions (mandatory convertible bonds). Due to their status as a mixed form of debt and equity capital, these bonds are also known on the market as hybrid or equity-linked bonds.

This article deals with CoCo bonds which are issued by banks in order to generate additional Tier 1 capital as defined in the Basel III Framework.

Purpose of issuing CoCo bonds

CoCo bonds are issued primarily by banks seeking to generate Additional Tier 1 capital so as to satisfy the statutory requirements stipulating an appropriate level of regulatory capital. These requirements are designed to improve the banks' loss absorbing capacity so that losses are no longer shifted to taxpayers but rather are borne by the banks' creditors themselves.

The term "Additional Tier 1 capital" is one of a total of three categories of regulatory own funds in accordance with Basel III, which also constitutes directly applicable legislation in Germany in the form of the European Capital Requirements Regulation (CRR). Additional Tier 1 capital is the second-most capable of absorbing any future losses after Common Equity (Common Equity Tier 1 capital – CET1 capital). Together, Additional and CET1 capital constitute “Tier 1 capital”. Generating own funds by issuing CoCo bonds thus represents one option for banks to gird themselves for future crises – alongside increasing their CET1 capital, e.g., through capital increases.

In order for a bank to be permitted to count the amounts generated from the CoCo bonds as Additional Tier 1 capital, CoCo bonds must satisfy certain requirements, including:

• they must stipulate a process according to which conversions or write-downs are implemented;
• they must have no maturity date;
• they may only be terminated, redeemed or repurchased by the issuer subject to prior authorisation by the relevant supervisory authorities;
• the payment of coupons must be at the issuer's discretion.

Increase of CoCo bond issues

The observable increase in CoCo bond issues can thus be seen as a consequence of the express desire of the European and national legislators to render banks more resilient in the face of future crises. The stricter qualitative and quantitative capital requirements of the CRR and the European Recovery and Resolution Directive are intended to serve this objective. It, too, is designed to improve banks' ability to absorb losses and can also be seen as one reason for the increase in CoCo bond issues.

The comprehensive assessment of major European banks – currently being conducted by the European Central Bank in preparation for the Single Supervisory Mechanism – may also be a further cause of this development. One element of the comprehensive assessment requires banks to undergo a stress test. If stress testing reveals deficits, the banks must raise capital, for instance in the form of Additional Tier 1 capital.

Selected risks

Many of the specific risks inherent to CoCo bonds arise directly out of the supervisory requirements set forth under Article 52 of the CRR which must be satisfied when structuring CoCo bonds before the amounts generated can be counted towards Additional Tier 1 capital. The statutory requirements are intended to help reduce the risk that taxpayer funds are used to bail out banks. The risk of loss should instead remain with those who stand to benefit from the opportunities – namely, the holders of the CoCo bonds.

Trigger event

One key risk is the occurrence of a trigger event described in the terms and conditions of the issue. This can result in a partial – or even total – loss of the capital invested since the bond would have to be converted into shares or be written down, either permanently or temporarily. It is hardly possible for retail investors to estimate the risk of a trigger event. This is because there are a wide variety of triggers on the market. Moreover, the term "CoCo bonds" is not protected and for that reason alone, investors should closely scrutinise the specific terms and conditions.

In order for the proceeds collected by CoCo bond issuers to be counted towards Additional Tier 1 capital, the conversion or write-down of the bonds must be made contingent on CET1 capital falling below a certain threshold. Depending on the margin between this threshold and the actual regulatory capital ratio at the issue date, investors receive a higher or lower coupon.

Investors should be well aware that the regulatory capital ratio's development depends on a large number of factors and is therefore exceedingly difficult to forecast. For instance, a loss of capital combined with an increase in additional risk-weighted assets can result in a reduction of the regulatory capital ratio to below the threshold which was set as the trigger.

Suspension of coupon payments

Even before a trigger event occurs, CoCo bonds issued with the objective of generating Additional Tier 1 capital are subject to a further risk, which is difficult to quantify. Issuers have the option to suspend agreed coupon payments, either temporarily or permanently. This effectively means a temporary or even permanent loss of the promised return.

The background to this also lies in the provisions of the CRR, which stipulates that it must be at the issuing bank's discretion to suspend coupon payments indefinitely at any time and on a non-cumulative basis. The issuing bank has an unrestricted right to use the funds it withholds to satisfy its own obligations. Skipped coupon payments are thus not disbursed at a later date – investors must write them off permanently.

Since coupon skips have no influence on whether or not shareholders receive a dividend, under certain circumstances holders of CoCo bonds are put at a disadvantage as compared to shareholders.

No redemption

Moreover, there is no guarantee whatsoever that the amount invested will be repaid at a certain date. It is only possible to terminate, redeem or repurchase such instruments if the supervisory authority issues an authorisation to do so.

Generally speaking, this is not even possible until five years after the issue of the CoCo bonds. Moreover, the competent supervisory authority may only grant such authorisation if the bank – simply put – continues to satisfy the regulatory requirements for sufficient capital adequacy.

Banks' conflicts of interest

In certain cases, banks which distribute CoCo bonds to retail investors may face a conflict of interest. In order to safeguard the interests of their clients they must, on the one hand, take responsibility for selecting suitable, appropriate products for them. Given their complex and innovative nature and associated risks, CoCo bonds are not likely to meet these criteria without exception. On the other hand, banks are responsible for increasing their ability to weather crises and improve their resilience by holding additional own funds.

It is therefore absolutely essential for firms to implement thorough and diligent measures to manage their conflicts of interest. In addition, they must meet particularly stringent requirements of conduct when it comes to CoCo bonds, for instance where the qualification of advisors and their duty to provide information to investors are concerned.

Position of other European supervisory authorities

In light of the increase in issuances of hybrid bonds, specifically CoCo bonds in the banking sector, these are receiving particular attention from regulatory authorities in Europe. The Joint Committee of the three European Supervisory Authorities EBA, ESMA and EIOPA issued a communication at the end of July 2014 reminding financial institutions of their legal requirements with respect to the distribution of financial instruments to retail clients.

In addition, the European Securities and Markets Authority (ESMA) issued a statement to institutional investors concerning the potential risks associated with investing in CoCo bonds.

Finally, at the beginning of August the British Financial Conduct Authority (FCA) issued a series of restrictions in relation to the retail distribution of CoCo bonds, which will be valid initially for one year beginning in October 2014.

CoCo bonds largely unsuitable for retail investors

In BaFin's view, CoCo bonds are a suitable means for improving the capital adequacy of credit institutions. In principle, it has no reservations against the distribution of such instruments.

However, in view of their complex product structure, their purpose, the difficulties in valuing them and the potential conflict of interest for banks, BaFin has considerable doubts as to whether CoCo bonds are a suitable product for retail investors. In general, they are not suitable for active distribution to retail clients.

Retail clients who wish to acquire CoCo bonds at their own initiative should give careful consideration to the described peculiarities and risks when reaching their decision. Going forward, not least due to the potential conflict of interest faced by banks described above, BaFin will therefore keep a close eye on which investors CoCo bonds are distributed to.