Governments are on the right side of the credit cycle, for once. Investor hunger for funky contingent capital securities is allowing Ireland and Belgium to recoup cash from costly bank bailouts. Weak growth prospects make raising bank equity expensive, but they leave bond investors desperate for yield. Governments should take the money and run.
The deals for Bank of Ireland and KBC Group are different, but both highlight a new use for contingent convertible bonds – securities that force losses on bondholders when banks' capital ratios fall below pre-set levels. The Irish government last week recovered a small profit on part of its bank rescue by re-selling on the market a €1-billion ($1.3-billion) contingent convertible it had used to recapitalise Bank of Ireland in 2011. The €750-million KBC deal is part of a joint equity-and-CoCo capital hike that will be used to repay €3-billion to the Belgian government.
Both operations involve so-called "high-trigger" CoCos, a risky new kind of bond that can force losses on bondholders even when the bank is still a going concern. KBC's deal will trigger if its core tier 1 ratio falls below 7 per cent, from an expected 12.3 per cent next year. Its CoCo would force a total writedown on bondholders, thus leaving shareholders with a significant gain.
It looks like a good deal, certainly for banks and governments. Raising ordinary equity is expensive despite the recent stock market rally. The bond market, meanwhile, is in a sweet spot; growth is low enough to keep government bond yields low, and fears of a euro zone crisis are receding, forcing investors to take risk. Investors are happy to buy high-trigger CoCos for lower return than the banks' cost of equity – despite their equity-like risk.
But the CoCo "reverse bailout" isn't for everyone. Investors like to see a substantial "cushion" between a bank's core Tier 1 ratio and the trigger point, when the CoCo pops. So the most likely candidates are banks in northern Europe, who are some way through their restructuring. The safety cushion may look weaker in southern Europe, where continuing austerity could push up bank losses. It may be some time before peripheral CoCos are ready to fly. And a return of the crisis could slam the window shut.