Worries about Deutsche Bank’s financial position sent its shares tumbling earlier this week and put the spotlight on so-called CoCo bonds, a financial instrument which has only existed for around three years.
What is a CoCo bond?
Contingent convertible bonds were introduced after the 2008 financial crisis, to give banks an extra layer of protection if they face renewed strains on their balance sheet.
Financial regulators also wanted to prevent a repeat of what happened during the crisis, when taxpayers pumped billions into struggling banks while bondholders mostly saw their investments repaid.
How do they work?
The bonds allow banks to skip interest payments without defaulting, and can be converted to shares or written down if a bank runs into financial difficulties. Investors in CoCo bonds would therefore bear the losses, but in return for taking the risk, the interest rate payments are higher at up to 7% compared with normal senior bank debt which pays around 1%.
CoCos are among the riskiest bank debt, with Fitch giving only a quarter of eurozone CoCos an investment grade rating.
How big is the market for CoCos?
The market is only around three years old but is now an important source of financing for banks, and is estimated to be worth around €95bn (£73bn) globally. The BBA, the UK banking trade body, says an estimated €40bn of CoCos were issued by European banks in 2015, while Bank of England data shows that the main UK banks issued around £4.5bn during the second and third quarters of last year.
Why are investors worried now?
The CoCo market is relatively new and untested. The current market volatility has raised concerns that banks may struggle to pay the interest on the bonds, may not buy them back as soon as investors expected or – in extremis – the bonds could become worthless.
There are strict regulations governing the bonds, including the trigger points at which they convert to equity or are written down, which are linked to the bank’s overall capital position. For example, to make interest payments on CoCos, banks have to calculate their available distributable items.
Deutsche Bank is seen as having less leeway than other large banks, which has helped prompt the current volatility. It insisted on Tuesday its payment due in April was safe, but investors are concerned it may struggle with its 2017 liabilities.
This has led to a slump in the value of its €1.7bnof CoCos, which fell to a record low of 70¢ on Tuesday compared with 93¢ at the start of the year. It is not alone: bonds issued by the likes of Royal Bank of Scotland, Barclays, Santander and Unicredit have also fallen.
Are there wider implications?
Bank shares have been plunging in recent days on fears that negative interest rates will hurt their balance sheets at a time when they are being encouraged to continue lending to businesses to help support economic growth. At the same time there are concerns about their exposure to struggling sectors of the economy such as oil and gas companies.
So the prospect of a default on CoCo bonds adds to the current uncertainty over the banking sector, and as well as making further issuance of such bonds a problem, could also undermine other credit markets.