Co-co bank bonds could make financial system 'unstable', warns expert

New bonds designed to prevent future bank bailouts could make the financial system dangerously unstable, Kames Capital bond fund manager Gregory Turnbull-Schwartz has warned.

His fear was expressed amid predictions that an avalanche of so called Co-co bonds – created in the aftermath of the financial crisis of 2008-2009 – will hit the markets in 2014 as European banks try to boost their capital strength. Nearly $10bn (£6bn) was raised in 2013.

Unlike traditional bonds, Co-cos either convert to equity when a bank hits financial trouble or can even be written off. The latter have become known as "sudden death" Co-cos.

But while they are supposed to absorb the worst of banks' losses and thus avoid the need for taxpayer bailouts, Mr Turnbull-Schwartz warned that a dangerous cascade could be created the instant that markets fear a bank could trigger this type of clause.

"If there is any hint that one of these new instruments is about to be tested by 'them' – whether regulators, issuers or others – the market will freeze as everyone tries to be the first to sell. If they cannot find buyers they will likely try to reduce their exposure by selling what they can, other bonds by the same bank or quite possibly other bank bonds. Just like during the previous crisis, suspicions once aroused will be difficult to douse and the regulators and central bankers are going to have to step in," he said.

Mr Turnbull-Schwartz said Co-cos could dangerously shake the global bond markets because "the stability of a bond market where there are contractual agreements with teeth and no possibility of losing money before equity investors are wiped out is different to a market where repayment of debt is discretionary and owners might choose to pay themselves dividends while not paying interest on their loans".

He said the way some Co-cos have been set up allows banks to treat them as an interest-free loan, defaulting on coupon payments even while still paying dividends to shareholders.

Traditionally, bondholders only take losses when shareholders have been wiped out by a bankrupt company because a bond is considered a loan. Co-cos, however, are different.

Mr Turnbull-Schwarz said regulators have in effect given in to bank lobbying and threats to decrease lending to the economy by allowing Co-cos, which provide them with a cheaper form of capital than issuing new equity, or shares. However, he did admit that "with significant diligence and remembering to properly respect the beast that is market liquidity we can make some money out of this misguided attempt to bolster capital".

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