CoCos are contingent convertible bonds that allow an investor to convert from debt (bond) into equity (stock). There is a predetermined stock price that the bond converts to like a traditional convertible bond. Unlike a traditional convertible, CoCos are convertible when a triggering event occurs and then it is a mandatory conversion, not optional.
Most CoCos have been issued by European banks thus far. However, American banks will soon follow now that the Federal Reserve is finished with QEII. Issuing CoCos is more advantageous to banks than issuing regular convertibles. Until an investor exercises the option, the bank does not need to count shares in its calculation of diluted earnings. Interest rates are also usually lower than traditional bonds because the holder will have potential for equity appreciation.
The triggering event for the European CoCos is when the bank’s portfolio of non-performing loans falls below a certain level. This causes the bank’s capital requirements to increase. The conversion of CoCos automatically moves debt from the balance sheet to equity/stock thereby helping the bank to solve its capital requirements. This will hopefully help avoid a financial meltdown like 2008.
This is a smart move for banks but whether it will be smart for investors remains to be seen. Wall Street is very creative in coming up with new types of investments. Most of them appear to be brilliant at first but when it comes to trial by fire, they have not always held up as expected.
CoCos will be coming to America soon. Some predict that more than $1 trillion of new CoCos will be issued over the next few years. I would expect interest rates to be attractive as investors get used to this new security. Keep in mind that there is no free lunch… especially on Wall Street. Going from a lender to an owner when the bank’s loan portfolio is under pressure may not be the best time to be converting.