What The Heck Are Cocos and Why Is Everyone Freaking Out About Them?

The global market sell-off that continued Thursday in the United States can be blamed on a lot of things, including China’s economic slowdown, low oil prices, and uncertainty about the U.S. Federal Reserve’s monetary policy. But there’s one obscure investment instrument that’s also contributing to the panic, especially in Europe, that is spilling across the Atlantic: Coco bonds.

Coco bonds are formally known as contingent convertible bonds. They were created in Europe by financial regulators as an insurance policy after the Great Recession to ensure taxpayers would not have to bail out banks if another crisis occurs and banks fall short on cash.

Here’s how they work. Cocos are a type of debt, with a string attached. Banks issue these bonds to buyers to raise cash. If a pre-agreed event occurs — say a stock price drops to a certain level — then the holders of the debt get an equity stake in the bank. This is the contingent.

They differ from normal bank bonds in that key way. If a bank — say Deutsche Bank, an institution whose health is at the center of Europe’s financial sector worries — is unable to pay off a normal bond, it would negotiate with the bond holder to pay off some of what it owes. This can be a long and complicated process.

Cocos allow bondholders to skip this. If a bank is short on cash and can’t keep up interest payments, then the borrower gets an equity stake in the bank, as opposed to having to negotiate a pay back. That’s the convertible part — debt converts into equity.

They were devised so that governments — and therefore taxpayers — wouldn’t have to step in to help struggling banks. If banks run low on cash and can’t keep up interest payments, the bonds convert.

This solves two problems: the bank’s debt load lessens, and its capital supplies increase because it has a new equity holder. Bond holders may not get all of their money back — which is why Cocos are considered very risky investments — but they will get a an equity stake in the bank that issued the Coco.

In Europe, the price of Cocos is plummeting, along with the value of European banks, some of which are down 40 percent on the year to date. Investors who hold Coco bonds are worried they won’t get their money back, and will be left holding shares in a bank that are far less valuable than what they paid for the bond.

For instance, earlier this week, Deutsche Bank’s 1.75 billion euro, or $1.98 billion, Coco bonds traded at 70 cents on the euro, as compared to 93 cents earlier this year. That’s the lowest level ever.

Concerns about the health of European banks trigger flashbacks to 2008, when U.S. banks, as well as banks in Europe, needed a bailout to avoid potentially collapsing, as Lehman Brothers did. Like them or not, banks are the heart of the global financial system. If they fail, the rest of the body fails with them.

“2008 is not that far away, and people still remember what happened then,” Benno Galliker, a trader at Luzerner Kantonalbank AG, told Bloomberg. “It’s kind of scary.”

That’s on top of the uncertainty about European banks to the stew of China’s slower-than-expected growth, historically low oil prices, and global equity drops. Germany’s DAX was down 3 percent Thursday, the Hang Seng index in Hong Kong dropped 4 percent, and the Dow Jones Industrial Average closed down 1.6 percent. Then add concerns that the U.S. Federal Reserve won’t raise interest rates next month because it fears it would hurt U.S. growth, an admission of economic weakness. It’s why 2016 is off to such a bad start. 

Photo Credit: Spencer Platt/Getty Images

This post has been updated with final DJIA close.