In introducing bonds and its different types, the paper highlights how bonds are a type of debt security. Bonds are effectively an IOU between a borrower (the issuer of the bond) and a lender (the investor who purchases the bond). Bonds range from simple bonds to complex bonds. Simple bonds have a fixed or floating coupon rate that does not change for the life of the security, pay interest periodically, have a fixed maturity of no more than 15 years, are not subordinated to other debts and does not attach any options to convert into equity. On the other hand, complex bonds allow the issuer to defer or capitalise interest payments under certain conditions, coupon rate could be re-set at certain times, give the issuer the option to extend them and are more characterised as hybrid securities.

What are Coco Bonds

CoCos or contingent convertible notes are slightly different to regular convertible bonds in that the likelihood of the bonds converting to equity is “contingent” on a specified event, such as the stock price of the company exceeding a particular level for a certain period of time. They carry a distinct accounting advantage as unlike other kinds of convertible bonds, they do not have to be included in a company’s diluted earnings per share until the bonds are eligible for conversion. It is also a form of capital that regulators hope could help buttress a bank’s finances in times of stress.

CoCos are different to existing hybrids because they are designed to convert into shares if a pre-set trigger is breached in order to provide a shock boost to capital levels and reassure investors more generally. Hybrids, including CoCos, contain features of both debt and equity. They are intended to act as a cushion between senior bondholders and shareholders, who will suffer first if capital is lost.

When it comes to the sales of CoCo bonds, they are a high-risk debt/equity hybrid offering an attractive option for banks to boost Tier 1 capital. CoCo bonds are perpetual, fixed-coupon debt securities that can either be converted into equity or be permanently (or temporarily) written down in the event of a certain trigger — such as if the bank’s Tier 1 capital falls below a certain margin — thus increasing the bank’s equity and recapitalizing in the event of a crisis. The key feature here is that, unlike existing hybrid debt instruments, the conversion is compulsory in CoCos, changing them from debt-holders to junior shareholders — making the bonds extremely high risk and thus, inevitably, giving them a high equivalent yield to make them worth holding. This compromise between debt and equity represents an uneasy truce between banks and regulators, allowing banks to meet the more restrictive requirements of Basel III regulation while still taking advantage of the more favourable tax treatment and higher investor demand for debt over equity.

Features of Coco

The paper highlights the two main defining features of CoCos as the loss absorption mechanism and the trigger that activates that mechanism. CoCos can absorb losses either by converting into common equity or by suffering a principal write down. The trigger can be either mechanical (i.e. defined numerically in terms of a specific capital ratio) or discretionary (i.e. subject to supervisory judgment).

Private investors are usually reluctant to provide additional external capital to banks in times of financial distress. In extremis, the government can end up injecting capital to prevent the disruptive insolvency of a large financial institution because nobody else is willing to do so. Such public sector support costs taxpayers and distorts the incentives of bankers. CoCos offer a way to address this problem. CoCos are hybrid capital securities that absorb losses in accordance with their contractual terms when the capital of the issuing bank falls below a certain level. The debt is then reduced and bank capitalisation gets a boost. Owing to their capacity to absorb losses, CoCos have the potential to satisfy regulatory capital requirements.

The paper looks in the role of the Basel Accords and what the regulators are seeking for financial institutions. Regulators try to ensure that banks and other financial institutions have sufficient capital to keep them out of difficulty. This not only protects depositors, but also the wider economy, because the failure of a big bank has extensive knock-on effects.

Shariah analysis

The paper concludes with a Shariah analysis of CoCo bonds and highlights that a bond is a debt obligation for which the issuer pays a pre-determined rate of return to the bond holder. There is no investment in any underlying asset; rather, the issuer has a personal right and a liability on his legal personality. A repayment of debt with interest is due to the bond holder. The payment for the bond is effectively a loan (Qard) from a Shariah perspective.

An alternative product proposed for Islamic banks is CoCo Sukuk. This would attempt to have a Sukuk with a conversion feature to comply with Basel III requirements. The Sukuk would have to be convertible into shares of the issuer or where the Sukuk can be exchanged for shares of a company owned by the issuer.

For a financial institution to issue CoCo Sukuk, it would likely start with the AT1 sukuk structure which is Mudarabah based on what is effectively a pro-rata share of the bank’s entire asset base. A Mudharabah Sukuk provides an ideal Shariah compliant structure to accommodate the features of AT1 capital, such as the discretionary profit payments. The Mudharabah Sukuk are classified as equity, therefore, they do not include principal loss absorption or equity conversion features. Periodic distributions are fully discretionary and non-cumulative