It is always tempting to live beyond your means. While credit is available, experience shows that humans have a hard time denying themselves immediate gratification at the cost of long term debt. This happens at the national level, as we can see in Europe, but also at the individual level. At some point the party has to stop. Wouldn’t it be great if some of your debts would automatically turn into cash once your debt reached a certain level? This is the idea behind contingent convertibles or “CoCo” bonds.

CoCos have recently been issued by several investment banks. Banks have good reason to take a lot of leverage because they are lending businesses. Their equity investors expect a 20% return on their shares. But banks get to borrow only slightly more cheaply than the rate at which they lend to their customers. The difference between the rate at which the bank borrows and lends is called the “net interest margin” and may be as little as 1%. How can we turn a 1% margin into 20%? The answer is balance sheet leverage. By borrowing money banks can scale up their balance sheet and total loans and boost their profit without issuing more shares. However boosting leverage increases risk because if loans start to go bad this can quickly wipe out the total value of equity and lead to bankruptcy.

CoCos are bonds that pay a fairly high coupon, but they are bonds with a twist. If the leverage of a company grows too large the CoCos stop being debt and turn into equity. Some call this “programmed balance sheet de-leveraging” because once issued conversion of CoCos is beyond the control of the company or the bondholders. This means that at a stroke the cost of financing the company’s debt drops because equity does not have to pay a dividend, whereas missing a bond coupon payment leads to bankruptcy. From the bondholders perspective they will stop receiving their large coupon and they will turn into shareholders rather than bondholders. From the point of view of existing shareholders, whose shares have become diluted, conversion is not an attractive prospect. Regulators love CoCos because they remove the immediate need for a bailout of over-leveraged banks from public funds.

The reason why CoCos are controversial is that conversion will only occur when companies are in trouble and will likely push depressed share prices down even further.Some people think that this makes  CoCos a dangerous instrument, but for some companies, usually financial companies, CoCos may make a lot of sense.

You can find out more about convertible bonds in Chapter 5 of the Financial Bestiarywhich is all about bonds.