CoCo bonds are short for contingent convertible bonds. These bonds are instruments or hybrid securities that convert to equity under certain conditions. These conditions are measurements of financial distress. After the financial crisis in 2008, CoCo bonds were created as help instruments during economic distress.
When a firm enters financial distress, it can convert CoCo bonds into stock. The firm will then modify its capital structure, recapitalize and stop bond payments. As a result, these bonds are expensive for financial firms. They have higher coupon yields to give the investor an attractive proposal. Even though the bonds are costly, they may be useful if the firm’s capital falls below a risk level. CoCo bonds have a higher risk than bonds, but lower risk than stock. Currently, these bonds are used commonly in European banks, but not yet in the U.S.
CoCo Bonds: US vs EU
CoCo bonds are common in Europe, where European banks have access to deductions when using these bonds. U.S. banks, on the other hand, do not issue these bonds (Arnold,2016). “U.S. banks don’t issue CoCos — they use a different type of preferred stock to boost their Tier 1 capital. But U.S. investors have been buying CoCos for the extra yield they offer.” (Linnane, 2016).
U.S. banks use different instruments to boost Tier 1 capital, such as preferred stock. However, US investors can invest in CoCo bonds and take advantage of the high yields, even is the bonds are not available in the U.S.
Preferred stock is a commonly used type of security that pays owners a fixed dividend continuously. Preferred stockholders have priority claims before the stockholders. They should receive their share before common dividends are paid in the case of financial distress when dividends are suspended. The preferred stockholders have the right to receive dividends before common stockholders. In a sense, preferred stock has characteristics from stock and bonds. Preferred stock bears risk between high stock risk and low bond risk
Non-financial Firms
Non-financial firms can also take advantage of CoCo bonds, but using this security will depend on the gain/loss relationship. Such firms also have the risk of bankruptcy and these bonds have the potential to provide extra capital in distress scenarios, but the expense ratio is high.
If financial firms offer high yield bonds, non-financial firms will have to offer similar yields to stay competitive. A percentage of CoCo bonds will increase the debt cost of capital and the overall cost of capital of the firm. If there are no additional benefits or regulations for issuing these bonds, non-financial firms can avoid the extra expense. Non-financial firms in volatile industries could prevent bankruptcy costs if they issue CoCo bonds.
