[Song Seungseop's Financial Light] 'Grenade Investment'... Coco Bonds Turned to Worthless Paper

Write-off upon bankruptcy... The Birth of 'Coco Bonds'
High yields drive Coco Bond investments
CS faces crisis, full write-off of Coco Bonds

Editor's NoteFinance is difficult. Confusing terms and complex backstories are all tangled together. Sometimes, you need to learn dozens of concepts just to understand a single word. Yet, finance is important. To understand the philosophy of fund management and consistently follow the flow of money, a foundation of financial knowledge is essential. Therefore, Asia Economy selects one financial issue each week and explains it in very simple terms. Even if you know nothing about finance, you can immediately understand these 'light' stories that turn on the bright 'light' of finance for you.

[Image source=Yonhap News]

The collapse of Silicon Valley Bank (SVB) sent shockwaves through Credit Suisse (CS). Its stock price plummeted more than 30% intraday, heightening fears of a crisis. However, with UBS expressing interest in acquiring CS, the worst-case scenario of bankruptcy seems to have been averted. Yet, the bond market remains in turmoil because CS fully wrote off its CoCo bonds. What exactly happened?

The Appeal of 'CoCo Bonds' Loved by Both Banks and Investors

CoCo bonds are a nickname for 'contingent convertible bonds.' They are a type of bond with a unique feature: upon meeting predetermined conditions, the principal is either written off or converted into common stock. These conditions refer to bankruptcy or equivalent risks. Simply put, if a bank faces a severe crisis, it does not have to repay the principal to bondholders.

Why were such bonds created? During the 2008 global financial crisis, the U.S. injected massive taxpayer funds to rescue failing banks. There was significant criticism about using public money to save private companies. This led to the birth of CoCo bonds, designed so that if a bank is about to fail, losses are absorbed by bond investors rather than taxpayers.

CoCo bonds were a win-win for both banks and investors. They are classified as capital rather than debt. Strictly speaking, CoCo bonds involve issuing bonds to investors and borrowing money. However, their key feature is that in times of crisis, the principal can be written off to cover losses. For banks, issuing more CoCo bonds increases their capital ratio, making them appear healthier.

There is also no burden of dilution. Financial institutions have various ways to raise funds, including issuing more shares. But this is not easy; issuing more shares reduces managers' ownership stakes and can lower stock prices. Since CoCo bonds are bonds, such concerns are unnecessary.

Investors also found CoCo bonds attractive because they offered higher yields than other bonds. Since these bonds automatically become worthless in a crisis, they naturally pay higher interest than regular bonds. In fact, in March 2020, when COVID-19 began, some global banks' CoCo bond yields rose to as high as 15%. Although there was concern about principal loss, investors were not overly worried, thinking, "The bank won't really fail, will it?"

Because of these characteristics, CoCo bonds have a fearsome nickname: 'investment with a hand grenade attached.' The hope is that the safety pin will hold, preventing the grenade from exploding. However, if the grenade does explode, it can cause severe damage, serving as a warning of the potential risks. Some economists have even criticized financial authorities for creating 'new risks unknown even to themselves.'

The Grenade Exploded... Bond Market and Banks 'Shaken'

And the grenade exploded. CS, facing a crisis, fully wrote off its CoCo bonds. The CS CoCo bonds had a clause stating that they would be written off if 'public sector capital support is provided to prevent bankruptcy, inability to pay significant debt amounts, or similar situations.' CS declared that this condition was met and wrote off CoCo bonds worth 16 billion Swiss francs. This means bonds worth approximately 22.5 trillion Korean won became worthless. This amount is more than ten times the size of CoCo bonds written off during the 2017 bankruptcy of Spain's Banco Popular, which was 1.35 billion euros (about 1.9 trillion Korean won).

The problem lies in the distortion of the loss-bearing principle. Generally, when a company collapses, losses are borne in order by shareholders, then bondholders. However, CS shareholders received one UBS share for every 22.48 shares they held in the merged company. Bondholders were left empty-handed, while shareholders, who should bear losses first, were compensated. The European Central Bank (ECB) issued a joint statement on the 20th, clarifying that 'shares are the first loss-absorbing instrument,' but it was ineffective. Switzerland is not an EU member, so it is not obligated to follow such rules.

There are reports that CS investors are preparing legal action. According to major foreign media, those who invested in CS CoCo bonds have begun contacting lawyers in Switzerland, the U.S., and the U.K.

Given this situation, concerns are growing that CoCo bonds issued by other banks may also be risky. Banks that issued large amounts of CoCo bonds have come under scrutiny. On the 24th, shares of Deutsche Bank, Germany's largest investment bank, plunged more than 14% intraday on the Frankfurt Stock Exchange. At one point, its CoCo bond yields rose to 23%. In the U.S., asset management firm Invesco's stock price fell 10.76% compared to earlier this month.

However, many believe the impact of the CoCo bond crisis on the domestic market will be limited. As of the 20th, domestic banks had issued CoCo bonds worth 31.5 trillion Korean won, which is a negligible portion compared to their total capital of 250 trillion won. Also, unlike CS, domestic banks' CoCo bonds do not have conditions allowing write-offs before common stock.