Essay About Trigger Event And Regular Bonds

Contingent Convertibles
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Contingent Convertibles (CoCos) are hybrid securities prevalent in the European markets which absorb losses in time of distress. Their primary purpose is to serve as a readily available source of tier one capital for banks in times of crisis rather than having the taxpayer bail the bank out. This aims to make banks more likely to issue equity in stable times, and more prudent in their risk management.  CoCos have two main characteristics, a loss absorption mechanism and the trigger event that activates such mechanism. A CoCo absorbs losses when triggered by converting to common equity or incurring a full or partial principle write-down thus lowering the liabilities. Triggers which enable such conversion can be numerical such as the bank falling below a required capital to assets ratio or based on supervisors’ judgement regarding the bank’s solvency. Banks sell CoCos when their balance sheet is stable and similar to regular bonds, coupons are paid to the investor. However, when such trigger event occurs causing the balance sheet to weaken, the CoCo converts from a bond and coupon payments can be halted as the investor converts from being a creditor to shareholder.CoCos became popular post financial crisis to avoid needing governments to bail them out in future crisis. In addition, they overcome the issue of investors unwillingness to provide additional capital to banks in times of financial distress. CoCos are a cheap means of improving a bank’s tier one capital ratios and in some countries coupon payments are tax deductible. Unlike convertible bonds the investor of a CoCo is obliged to the conversion meaning they cannot choose the best time to convert. This mandatory conversion results in an unavoidable transfer of value from either existing shareholders or CoCo holders depending on the conversion ratio. In addition, through anticipating value transfers, classes of investors are incentivised to decline the stock price to lift the chance of conversion and vice versa. This causes systemic instability and taxpayers can find themselves dealing with the consequences and required bailouts (