European regulators are calling on investors to be sure that they fully understand complex new securities that are being issued by banks as part of the effort to end “too big to fail” policies.
The European Securities and Markets Authority (ESMA) issued a statement today alerting investors to the sorts of risks that they should be aware of when buying issues of an emerging new asset class, known as contingent convertibles (CoCos). These sorts of securities are typically structured to convert from debt into common equity in the event that the issuing bank runs into financial trouble. They are being developed by banks to bolster capital and to reduce the risk that a troubled bank would ever need a government bailout.
“If they work as intended in a crisis CoCos will play an important role to inhibit risk transfer from debt holders to taxpayers,” the ESMA says. “However, it is unclear as to whether investors fully consider the risks of CoCos and correctly factor those risks into their valuation.”
The ESMA stresses that there are specific risks to CoCos, and it says that investors should take those risks into consideration prior to investing in them. Those novel risks include trigger level risk; the risk of coupon cancellation; capital structure inversion risk; and, call extension risk. Additionally, it notes that there may be unknown risks, as “the structure of the instruments is innovative yet untested.”
“In a stressed environment, when the underlying features of these instruments will be put to the test, it is uncertain how they will perform,” it says. “In the event a single issuer activates a trigger or suspends coupons, will the market view the issue as an idiosyncratic event or systemic? In the latter case, potential price contagion and volatility to the entire asset class is possible. This risk may in turn be reinforced depending on the level of underlying instrument arbitrage. Furthermore in an illiquid market, price formation may be increasingly stressed.”
The ESMA notes that these investments offer attractive yields, “which may be viewed as a complexity premium… yet it remains unclear whether investors have fully considered the underlying risks.” Finally, it suggests that only knowledgeable institutional investors are equipped to do the sort of analysis required to fully assess the risks of these new, complex instruments.