Contingent capital seems to feature in almost every discussion about bank capital — a profile out of all proportion with its actual use so far. But true Cocos have been left out of Basel’s design of the capital structure. And the European rules are yet to be fully laid out for new style hybrids, which can also include principal write-downs or equity conversions.
But while markets wait for regulators to make up their minds, some bankers have turned their thoughts to whether the structure could play a role for other borrowers. Corporates, for example.
The idea is an attractive one. A bond that converts to equity at a certain trigger point could perhaps be assigned greater equity credit by ratings agencies. The company’s equity holdings would be magnified, at a cost well below that of a rights issue. This, in turn, would presumably bring down the cost of the borrower’s unsecured funding.
But start thinking through the details, and the potential pitfalls are double that of a bank Coco. For a start, a coherent trigger point is harder to come by. There have been discussions about market capitalisation triggers for bank Cocos, but the consensus measure seems to be regulatory capital ratios, a figure that is already widely and regularly reported. There is no equivalent for corporate borrowers.
A trigger could be the debt to earnings ratio — but it would need to be structured in such a way that one poor quarter didn't flip the switch.
The other question is investor demand. FIG investors are wary of instruments liable to permanent write-down. Deals can get done (witness the overwhelming demand for Rabobank’s trade earlier this year), but many institutional investors are unhappy about taking the risk of a haircut when shareholders do not also face that downside.
That makes equity conversion preferable, as the investor hierarchy is preserved. But many fixed income investors would be forced sellers if a deal did convert, and in an equity environment that could be fairly ugly.
With these uncertainties, corporate Cocos are, at best, an interesting idea. And without regulatory pressure to introduce them, that is how they are likely to stay. To those of you pitching them, good luck!