The Convertible Contingent Bonds, they have become a financial tool for banking institutions in the face of the recurring need to meet capital requirements. In this article, we present to you what CoCos are and what their benefits are.
Convertible Contingent Bonds allow a quick recapitalization of the acquirer.
Convertible Contingent Bonds.
In the new era of the world of banking and finance, governments have updated financial legislation with a view to protecting the interests of the public and especially of their banking institutions. To this end, minimum capitalization quotas are required to respond to future eventualities that may compromise the stability of the financial system. For this reason and to ensure compliance with the minimum capital requirements by financial institutions, the Convertible Contingent Bonds (CoCos), a type of bond with characteristics of debt by paying interest to the investor and capital by having the mandatory ability to convert it into shares for the company or entity that has issued them.
The Convertible Contingent Bonds, have pre-established conditions by the issuing entity, mainly mandatory conversion into shares, which differs from a normal convertible bond, where it is the acquirer who decides whether to convert them or not, and if not, the issuer returns the investment by repaying the debt as a generic operation; in the CoCos, the purchaser lacks the power to convert or not the same; in this sense, the Convertible Contingent Bonds, allow a quick and cheap pre-agreed recapitalization of the financial institution by converting it into shares.
How do Convertible Contingent Bonds work?
Generally, Convertible Contingent Bonds, are acquired by the entities of the financial system that present a potential deficit in compliance with the minimum capital standards; Consequently, the decisions of its convertibility rests in the hands of the issuing entity, who will define the conditions prior to the transaction of the agreement and frequently, these pre-established circumstances pressure the conversion into shares by the investor in view of the imminent fall in the capital level of the the institution below the minimum established standards, that is, if the bank is in an unfavorable position to meet its capital quota, it will have the obligation to convert its debt into capital by converting it into shares in favor of the issuer .
Advantages of Cocos
As we have mentioned before, the Convertible Contingent Bonds They allow a rapid recapitalization for the investor with the pre-established condition of conversion into shares. In this way, the institutions have managed to remain fully solvent in meeting their minimum capital standards before the regulatory bodies of the financial system, making the CoCos an excellent support tool for meeting their obligations.
For acquirers
The Convertible Contingent Bonds They are highly attractive both for the regulators of the financial system and for the banks, who recurrently demand capital and it is here, where the CoCos, reinforce the patrimony of financial institutions at critical moments for the fulfillment of their obligations before the regulatory bodies of the Finance system. In this way, they have the expeditious effect of reducing the level of debt of the investing entity by the amount of the bond, increasing its level of recapitalization in the same proportion.
Convertible Contingent Bonds have numerous advantages for both investors and issuers.
Another advantage for the acquirers is that the fact of investing in these converts this tool into a fixed-income financial asset while the bond is valid, by receiving the payment of the interest established at the time of the issue agreement date. , which makes the investor perceive it more as capital than as debt.
The Convertible Contingent Bonds they are above the shares before the conversion, so that in a possible bankruptcy, the investors of the CoCos would collect first than the shareholders of the institution.
For issuers.
As for the issuers, the CoCos are considered as a type of capital from the moment the issuance agreement operation is executed, when the capitalization levels of the investing entity and the potential drop in capital standards are calculated. that must comply with the regulatory bodies of the financial system, since they must comply with the conversion of debt into capital through payment with their shares, which will allow the issuer its shareholding in the investors' capital.
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Are Contingent Convertible Bonds risky?
Like any financial instrument, Convertible Contingent Bonds, have their own characteristics that attribute certain levels of risk to them and the fact that they receive a high return is the main consequence that these Cocos bear a higher risk.
However, within the financial regulations for the different banking institutions, endless measures have been implemented that require efficient administration; Based on this principle, we must assume that the balance sheets of financial institutions, both issuers and investors, are clean and productive and their capital covers risk-weighted assets. Being so, the Convertible Contingent Bonds, can generate very high returns where a single risk can be assumed: that the capital of the investing entity does not cover the risks of its assets; however, financial legislation has been establishing policies to deleverage their balance sheets and increase their income.
Likewise, given that the circumstances that frequently force the conversion are usually when the investor's capital level falls below the minimum established standards, the debt becomes capital at the most critical moment for the investor; Otherwise, if the financial circumstances remain favorable for the investor, the Convertible Contingent Bonds They assure the holder constant profitability through the payment of the corresponding interest, according to the pre-established conditions at the time of the issuance agreement operation.
If you know well the Contingent Convertible Bonds to invest, the investment makes sense.
Therefore, the risk levels of the CoCos are considerably low in contrast to their effective profitability, as well as the purpose pursued with their investment by trying to increase capital levels at critical moments for the investor.