DNBulletin

DNBulletin: Limited interest from euro area investors for European contingent convertible bonds (CoCos)

Datum 29 mei 2017
Theme Supervision
Belangstelling vanuit eurogebied voor Europese CoCo’s beperkt

The market for CoCos in the European Union is a young, expanding market. CoCos are hybrid bonds that are designed to absorb losses if a bank's capital falls below a predefined limit. DNB research shows that most investors in European bank CoCos are from outside the euro area.

Regulation leads to expansion of the Coco market

Banks are required to hold sufficient capital to cover the loans that they provide, and they can use CoCos as additional Tier 1 (AT1) instruments to comply with their capital requirements. As a result, the European CoCo market has grown to EUR 182 billion in recent years (Figure 1). Following substantial issuances in 2014, the level of issuances decreased in the years 2015 and 2016, as several banks had already reached their desired volume of CoCos in 2014 and only few new market entrants opted for CoCo issuances. The stress in the CoCo market in early 2016 also depressed the number of new issuances. It emerged from concerns about the profitability of banks and uncertainty regarding coupon payments.

Annual issuance figures for CoCos (EUR 25 billion) are still lower compared with other types of bank bonds, including the senior unsecured and Tier 2 instruments (EUR 150 billion and EUR 40 billion, respectively). Tier 2 instruments are subordinated bonds, which can be used in addition to Tier 1 capital to meet the 8% capital requirement. As CoCos can be converted into shares or written down if a bank's capital ratio falls below a predetermined level, they carry higher and more specific risks for investors than other types of bonds. On the other hand, returns on CoCos also tend to be higher.

Figure 1: Expansion of the European CoCo bonds market

Figure 1: Expansion of the European CoCo bonds market

European CoCos mostly favoured by investors from outside the euro area

DNB research shows that most CoCos are held by parties from outside the euro area. Investments in European CoCos by banks, insurers, pension funds and other financial institutions from within the euro area are relatively limited (Figure 2), partly because most CoCos do not have an investment-grade status (i.e. their rating does not exceed BBB-) and they are mostly issued in US dollar.

Investors from outside the euro area are holding almost two thirds of European CoCos (EUR 115 billion). Potentially this  non-euro area investor base could lead to more volatility, but it also limits the interdependence between banks and other financial institutions in Europe.

Figure 2: Investor base for European Cocos

Figure 2: Investor base for European Cocos