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High-yielding cocos up the risk ante

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For bank investors – and depositors – the stakes keep rising. Barclays has sold its second issue of contingent capital notes. These are the latest iteration of the so-called cocos that have emerged after the financial crisis as banks have sought ways to boost their capital (as if to underscore that point, the Barclays deal was taking shape as the U.K.'s Financial Policy Committee said last week that the nation's banks faced a capital shortfall of £25-billion [$39-billion]).

Earlier versions of cocos converted to equity based on capital levels and other triggers. Barclays' deal, and other recent issuances, go further. Barclays' notes undergo a writedown to zero if its Tier 1 common equity ratio falls below 7 per cent, even if the bank remains a going concern. And there will be no givebacks: the writedown is permanent, even if prospects improve.

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For investors convinced that breaching the trigger is not a credible threat (or those desperate for yield), the 7.75 per cent yield on the $1-billion of 10-year bonds compares favourably with Barclays' senior debt and existing Tier 2 securities, which trade at 2.5 per cent and 4 per cent, respectively. Barclays' current Tier 1 common equity ratio is 11 per cent. Skeptics simply see a bond that is riskier than equity, inverting the traditional hierarchy of bond and equity investing, with little reward.

Considering the fate of Cypriot depositors, the total writedown (or "sudden death") bonds, with their juicy yield, may not look like so bad a deal – unless depositors somewhere are getting 7.75 per cent. At least there is some additional payment for the risk of loss. But recall, as well, the government rescue of Dutch bank SNS Reaal, where the losses stretched to junior bondholders. Investing in the lower end of bank capital structures while the economy, sovereign finance and the banking system are in simultaneous flux is becoming more of a gamble.

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