Are you familiar with NVCCs and CoCos?
In 2014, financial institutions in Québec began issuing NVCC (Non-Viability Contingent Capital) instruments, which include CoCo (Contingent Convertible) bonds.
Why do financial institutions issue this type of instrument?
In response to the 2008 financial crisis, the Basel Ⅲ Accord1 now requires banks to be more resilient by strengthening their capital base (Tier 1 capital, consisting of funds raised through the issue of common shares, and retained earnings).
As a direct consequence of the options available to banks through Basel Ⅲ, NVCC instruments were created to gradually improve capital ratios by issuing low-cost quasi-equity2 instruments.
What are NVCC instruments?
NVCCs are hybrid financial instruments. They have the traits of both debt and equity securities. Convertible bonds are the most common form of hybrid instruments.
CoCos (contingent convertibles) are a special category of convertible bonds. They have a protective mechanism that converts them into common shares when a trigger event threatens an institution’s viability. A trigger event may occur if a financial institution does not have the cash required to meet its commitments. In Canada and Québec, only the Office of the Superintendent of Financial Institutions (OSFI) and the Autorité des marchés financiers (“AMF”), respectively, have the authority to decide whether a financial institution is or is about to become non-viable. In Canada and Québec, the only authorized protective mechanism is conversion into common shares.
What is the difference between CoCos and traditional convertible bonds?
A traditional convertible bond gives the holder the right to exchange the asset for common shares at particular periods and at a certain rate, whereas CoCos will automatically be converted following a trigger event, as defined in Canada and Québec by OSFI and the AMF, respectively. Take time to read the prospectus in order to understand the conditions for conversion.
What are the advantages of NVCCs?
- For investors, these products offer higher returns than do government or corporate bonds in a low-interest environment.
- For financial institutions, CoCos provide a lower-cost alternative to share issues for raising capital.
- As for the State (and taxpayers), the goal of this type of product is to have bondholders share or assume the cost of bailing out a failing financial institution.
What are the risks?
- NVCC instruments are complex.
- NVCC instruments do not have a long history and associated risks may not be fully understood.
- When a trigger event occurs, the viability and future of the financial institution are uncertain, so investors might find themselves holding shares with little value.
Make sure that you understand your investment and it is in line with your investor profile.
1 The Basel Ⅲ Accord is a regulatory framework for banks aimed at strengthening the financial system further to the 2008 financial crisis.
2 Quasi-equity includes convertible bonds, among other instruments.