Co-Cos: Contingent Convertible Bonds

By THIS IS MONEY
Updated:

 

Contingent Convertible Bonds - dubbed Cocos for short - are tipped to become one of the key tools used by banks to ensure they have enough capital to weather future financial crises.

Lloyds Banking Group is offering holders of certain types of its bonds and preference shares the option to exchange those securities for cocos.

So what are they?

The key feature of cocos is that while they are bonds - in other words an IOU for money loaned to the bank - they can convert into equity - an actual ownership stake in the bank. In the case of Lloyds the Cocos will convert from bonds to shares if the bank's reserves of capital run short due to a financial crisis.

Specifically the conversion will take place if core tier one capital falls below 5% of total assets. For the regulators cash invested in shares in a company is counted as core tier one capital but bonds are not.

What are they for?

The reason is simply that in the event of a company failing or running into difficulty shareholders - the owners of a company - are the last in the queue to be repaid. Their money is locked in. Bondholders are creditors and in a crisis join the queue along with other creditors like bank account holders.

So the Lloyds Cocos mean that in the event of the bank running low on capital reserves the coco holders will see their bonds turn into equity. In effect their money will become more at risk at that moment.

So why would anyone exchange bonds for cocos?

Because of the higher risk the cocos typically pay a far higher interest rate than the bonds they are replacing. In the case of Lloyds this is particularly marked because the European Commission has ruled that Lloyds cannot pay coupons on many of its bonds as the price for having been bailed out by the UK government. It is seen as unfair that taxpayer money might go towards rewarding private investors.

So for holders of bonds and certain types of preference shares the choice is between holding onto their current bonds and earning no interest or accepting the cocos which means they will get quite a high interest rate - as high as 11% in some cases - but run the risk of losing their money if the bank hits another crisis.

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