Do you remember the mid-1990s film Speed?
It was not a complex plot: a bus would blow up if its speed dropped below 50mph and Sandra Bullock had to keep driving it very fast or else all the passengers would die.
Good. You are already half way to understanding contingent convertible bonds, or CoCos.
The analogy is not quite perfect, so instead imagine that Ms Bullock had to drive very slowly on the motorway, downhill with a following wind. If she ever reached as fast as 50mph then it would all go Pete Tong. That is a CoCo.
Contingent convertible bonds are also known as enhanced capital notes. The latter, however, have no connotations of chocolatey breakfast cereals and are thus only referred to by regulators and analysts.
Their popularity (or notoriety) originates from the great financial crisis, when everyone decided it was rather unfair that taxpayers should have to pay to rescue dastardly banks while bondholders were laughing, as they say, all the way to the bank.
Everyone agreed that we needed something new. Something that was not quite a bond, not quite equity but yet which would save us all from having to rescue another reckless bad bank.
The ‘solution’ was effectively the CoCo.
This is a bond that will convert to equity if a pre-determined event comes about. Some form of ‘moral hazard’ for bondholders.
This predetermined event is known as the ‘trigger’. This is most commonly something bad happening to the issuer.
In the UK, experience of CoCos typically extends as far as Lloyds Bank; here the trigger is Lloyds tier 1 capital ratio (we may tackle bank capital ratios in a further Jargon Busting, but bear with us for now) falling to 5 per cent.
Banking regulators have deemed that 5 per cent is not enough; should this happen the bank will need less debt and more equity and the CoCos will automatically convert into equity.
That seems a pretty rough deal. The CoCo converts into equity when the bank is in crisis. When things are at their worst, your bond suddenly becomes equity. Whoops.
Who in their right mind would want one of those?
Lots of people, is the answer, because to compensate for this risk of explosion, CoCos pay eye-wateringly high coupons. The headline rate of interest on Lloyds CoCos goes up to 16.125 per cent, for example.
Does this not look like very reasonable compensation for backing Antonio Horta-Osorio’s ability to keep the bus at the right speed?
Not according to the FCA, which imposed a moratorium last August on sales of these “risky and highly complex” investments to retail investors.
CoCos come with acres of small print and are awash with weasel words.
It turns out the FCA was warning against itself, or specifically the Prudential Regulatory Authority.
