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Difficulty: Advanced
1) TLACs and Cocos are types of bank bonds that can provide a “bail-in” for the issuing bank
They were invented after US banks received government bailouts during the Great Financial Crisis.
2) “Bail-in” — the bond can be written-off OR converted to equity
“Bail-in’s” are to help the bank buffer up its capital ratios.
3) TLACs & Cocos differ in what triggers a “bail-in” and in coupon features
TLACs have a soft trigger while Cocos have both soft and hard triggers (the latter occurs when the bank’s CET 1 ratio falls below the Coco’s trigger level). TLAC coupons are non-deferrable while Coco coupons are deferrable and non-cumulative.
3) TLACs and especially Cocos are risky instruments
They can provide an attractive return when markets are steady, but are volatile when the economy sours.
Not all bank bonds are the same
Total Loss-Absorbing Capacity bonds (TLACs) and Contingent Convertible bonds (Cocos) are the riskier lot of bank bonds. They are still not widely understood, even within the financial community. Cocos are generally considered high risk products within Private Banks, with extra precaution taken when marketed to would be investors. For instance, some banks have restricted recommendations of such bonds only to clients who have opted for the highest risk profile, while other banks have limited the order-taking and advisory-giving of such bonds to specific staff within the bank. With such restrictions in place, you know for sure that such bonds are not meant for your typical mom and pop.
For those who are interested, we’re here to break down the concept for you.
The rough concept of TLACs and Cocos
In 2008/09, “too big to fail” happened and pitted taxpayers against bondholders. While banks were receiving these bailouts, some of them were still paying out distributions to their bond holders. Logically, this didn’t seem fair. Why was the government risking taxpayers’ hard-earned money while bond holders suffered no losses?
So, TLACs were invented! TLACs are bonds that can provide a “bail-in” for the banks. Banking regulators came up with the concept of total loss-absorbing capacity (TLAC), bonds that can provide a “bail-in” for the bank when it is on the brink of failure. A “bail-in” essentially refers to a debt write-off or debt-to-equity conversion from bondholders, with the intention of buffering up the bank’s capital ratios.
Contingent convertibles (Cocos) refer to the highest risk subset of TLACs and typically the most junior within a bank’s capital stack after common equity.
TLACs and Cocos usually have lower credit ratings (compared to non-TLAC eligible bonds). This is in line with the seniority of claims if the bank fails. In the example below showing a variety of bonds from Credit Suisse, check out the light grey columns. One can observe that the non-TLAC senior unsecured bond has A1/A+ credit rating, the TLAC senior unsecured bond has Baa2/BBB+ credit rating, the Coco Junior Subordinated bonds have even lower credit ratings that fall under the High Yield category.
Main differences between TLACs & Cocos
One note before we begin, while we mentioned earlier that Cocos are technically a subset of TLACs, they are often treated as different type of bond when they are marketed. As such, for the purposes of the rest of this article, we will be using the term “TLACs” to refer specifically to non-Coco TLACs.
LOSS ABSORPTION APPLICATION.
- TLACs have a “soft trigger” for when they can be used to provide a “bail-in” for the bank. I.e. when they can have their principal value written down. This “soft trigger” is discretionary and usually happens when a regulator deems that the bank has reached a point of non-viability.
- Cocos have both soft and “hard/mechanical” triggers. A hard/mechanical trigger occurs when the bank’s CET 1 ratio falls below the Coco’s trigger level. (Explained in the next section)
COUPON PAYMENTS.
- TLAC coupon payments are non-deferrable
- Coco coupon payments can be deferred at the bank’s discretion and are non-cumulative. For Cocos, this means a bank can refuse to pay you a coupon and that would not constitute a bond default.
Comparing Cocos from the same bank
LOOK AT THE COCO’S CET 1 TRIGGER LEVEL
- What is CET 1 (Common Equity Tier-1)? The CET 1 ratio is a measure of capital adequacy for the bank. The CET 1 trigger level of a Coco indicates the ratio at which the Coco will be used to bail-in the bank.
- A Coco with a lower CET 1 trigger level, means a lower probability of encountering a bail-in event, and therefore this Coco’s yield should also be lower (when compared to a Coco with a higher CET 1 trigger level from the same bank).
- Example: The CS 6.25 Perp in the below table has a lower CET 1 trigger of 5.125% than the CS 7.5 Perp which has a CET 1 trigger of 7%. This lower risk results in a yield to maturity/call of more than 1% less.
LOOK AT THE EQUITY CONVERSION TRIGGER
- If Cocos from the same bank have similar CET 1 trigger levels…
- …the Coco with an Equity Conversion trigger would likely result in less losses than a Permanent Write-down when CET 1 trigger levels are breached. As a result, expect to get lower yields from Cocos with Equity Conversion trigger features (CS 7.5 Perp vs CS 7.125 Perp in the table above).
THEN LOOK AT THE YIELD
- Less risk does not mean better investment! But if you do take on more risk, you’d want to be properly compensated by seeking higher yield from the “riskier” Coco relative to the less risky alternative from the same bank.
Comparing Cocos from different banks
YOU’D WANT TO CHECK THE CREDIT WORTHINESS OF THE BANK
- That’s the work of an analyst. A bank’s credit worthiness depends on a variety of factors, e.g. the capital structure of the bank, the economic outlook, the cash flow and liabilities management, loan book quality etc.
- Of course, CET 1 trigger levels, equity conversion triggers, call features and other aspects of the individual bonds still matter.
Summary on bank bonds: Questions to ask
Take the below Credit Suisse USD bonds for example. As you might have noticed, the yields between the five bonds vary widely, commensurate with varying levels of credit risk, despite them all being issued by the same bank.
Before making a purchase, a saavy investor would typically have asked:
- Is the bond TLAC-eligible (Total Loss-absorbing Capacity) or a Coco (Contingent Convertible)?
- If it’s a Coco, what is the Common Equity Tier-1 ratio (CET 1) trigger level?
- If triggered, would that result in a permanent write-down, equity conversion or temporary write-down of the bond?
- Does the bond have any callable features?
- Is there a coupon reset feature? What and when would that be?
These bonds can be volatile, especially when the economy sours
When markets are steady, TLACs and Cocos can provide an attractive return.
However, such bonds can be quite volatile when the economy sours. For example, the Credit Suisse 7.5% Coco experienced a price decline of 26% during the sell off in February-March 2020 (image below)
In conclusion, bank bond investors should no longer hold onto the mindset that banks are “too big too fail” and that their bond holdings are safe.
In the case of Cocos, a bank does not necessarily even need to fail to permanently write-down the value of its Cocos to zero.
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