During the previous big economic crisis around 2008 - some argue from which we have still a long way to go to fully recover - when banks were bailed out by governments, the shareholders tended to suffer big losses. Bondholders however, did get a way relatively unscathed. Since then regulators regulators have pushed for banks to fund their activities with less debt and more loss-absorbing capital.
Accepting this challenge the banks came up with something called contingent convertible bonds, or CoCos for short. In it’s simplest form, a CoCo bond is a hybrid capital security that absorb losses when the capital of the issuing bank falls below a certain level.
As pointed out recently by The Economist among others, the value of certain CoCos has recently fallen dramatically. The reason for this being not a concern for the capital situation of the bank(s) in question, but rather a lack of profits diminishing the subset of earnings from which interest on CoCos must be paid. Thus it seems that the CoCos have failed to fulfil at least part of the original idea of taking money away from investors, but not just when the profits look bleak but when the capital is actually needed.
Not that anyone did not see it coming. In this blog post posted around the time for the issuance of some of these CoCos, FT Alphaville speculates that the biggest danger facing investors might not be the trigger point at which the CoCos convert into shares, but rather any restrictions on its distributions, i.e. no coupons for CoCo bondholders.
This raises the question of whether investors correctly priced and managed the the risk inherent in this type of bond.