Investors should pay attention to the risk of loss absorption and the coupon reset mechanism.
The first is the risk of loss absoprtion. There is a trigger mechanism in CoCo bonds. Generally, when the Tier 1 capital adequacy ratio of the issuing bank drops below a certain level (generally 5.125% to 7%) or when the regulatory authority makes a judgement that the bank is unable to continue its operation, it will reach the trigger level. This will force the conversion of CoCo bonds into ordinary shares or writing down of the principal of the bonds in accordance with the terms of its loss absorption mechanism. Holders of CoCo bonds might need to bear part of the loss or a total loss of their investment.
Another loss absorption risk is that CoCo bonds may cancel the interest payment. The ability of a bank to deliver interest payments based on certain requirement for the bank’s capital. It has to calculate a maximum distributable amount for interest payment according to its profits when the capital is insufficient. Since the interests are cancellable and non-cumulative, such cancellation would not constitute an event of default. However, the impact of the inability to pay debts is rather huge, so the issuing bank will not cancel interest payments without a sound reason.
Besides, most of the CoCo bonds are perpetual bonds with callable features, typically 5 or 10 years after issuance. The interest of CoCo debt usually turns into floating interest after the first call date. Issuer would consider factors such as sufficiency of capital and the cost of issuing new debts, before choosing whether to call back the bond. If the issuer does not exercise the call at the call date, the interest rate reset clause will be triggered, and the interest rate may change according to the market benchmark interest rate.