FCA acts on concerns over risky coco bonds

By Robin Henry, Partner, Collyer Bristow LLP

Published: 15 December 2014

The UK Financial Services Authority (FCA) has used new consumer protection powers for the first time in imposing a one-year ban on the sale of contingent convertible bonds (coco bonds). The FCA announced on 5 August 2014 that it would prevent the sale of coco bonds to retail investors from 1 October 2014 for one year on the grounds that the bonds were “unlikely to be appropriate” for the mass retail market.  Concerns have previously been raised about the risks of investing in coco bonds. Many private investors may not have been made fully aware of the serious risks which these types of bonds involve.

This is the first time the FCA has prevented a product from being sold without issuing a consultation first. During the temporary ban, the FCA is planning to publish a consultation paper about proposed permanent rules on coco bonds. Following consideration of feedback, the FCA aims to publish a policy statement in Q2 2015, with final rules to be scheduled to take effect on 1 October 2015, when the temporary ban expires. The FCA’s decision to restrict the sale of coco bonds also raises questions as to whether it will want to consider banning the sale of other products to retail investors.   

Although the ban imposed by the FCA is intended to reduce the risks to which retail investors are exposed, there are arguments that the restriction on the sale of coco bonds goes against the regulator’s own desire to reduce the overall risk in the financial system. When coco bonds were introduced, there was a hope that they would help protect banks from insolvency. 

Over the last three years, this 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 coco bonds, trades in these securities have reached €75 billion on European markets and are predicted to reach €100 billion by the end of 2014¹.

As European banks prepare themselves for the impending stress-testing of Basel III, coco bonds have provided a cheap means of improving the bank’s 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. 

Banks are required to pay coupons on these bonds up until the occurrence of a particular event called a “conversion trigger”. A conversion trigger may be the bank crossing a nominal capital to assets ratio, or a decision by the regulator that the bank is “in trouble”. At this point the bonds will either convert into shares or will simply be written down to zero. Since the losses are borne by investors rather than the taxpayer (as a result of a bail-out), the benefits from regulators’ point of view appear at face value to be clear, but concerns have been raised that in practice, coco bonds might actually worsen a future banking crisis because the effect of a conversion trigger being sprung may add downward pressure to a falling stock price. It is for this reason that coco bonds have been called “death spiral bonds”.

Nonetheless these bonds have proved popular with investors. The coupons on such bonds will, depending on the perceived creditworthiness of the bank, range between 7 to 9, and even up to 10%.  There has been a bull-market for these products, to say the least. In late 2012, Barclays issued $3bn of contingent convertible bonds which would wipe out investors if the bank’s core tier one capital ratio fell below the 7% minimum specified by international regulations. Investors were attracted to a well-known name offering a coupon of 7.625% for 10 years and demand was purported to reach $17bn. In January 2014 the French bank Crédit Agricole received $25bn of orders for its $1.75bn issue of coco bonds paying a coupon of 7.8%. In March this year Spain’s Santander and Denmark’s Danske Bank joined the ranks of Barclays, Credit Suisse and UBS by offering coco bonds in what has so far been an almost entirely European phenomenon. Bank of America Merrill Lynch has recently initiated its first coco bond index, signalling that the market is entering the mainstream.

There are, however, serious risks for the investors. In good times, the bonds act in the same way as normal high yield bonds. However, the higher coupons payable may not be sufficient recompense if the trigger event occurs, particularly as a result of a regulator taking a unilateral decision to warn of problems for the issuing bank. In August 2013 journalist John Dizard, writing in the Financial Times, described coco bonds as “financial perpetual motion machines²”. Since then, in February 2014, Standard & Poor signalled an intention to downgrade the security rating of coco bonds stating that, “We are signalling potential downgrades (by at least one notch) of securities that banks have been issuing in record numbers to meet new regulatory requirements". An employee at S&P was quoted as saying “There is a greater risk of a regulator requiring a bank to withhold the coupon long before it hits the trigger for converting into equity or being written down³".

Following a trigger event, investors may find themselves either ranking equally with shareholders or even subordinated to them.  This is the concern which has led the FCA to take action now. 

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