The whole concept of a contingent capital bond, or CoCo bond as it is more popularly known as, has been called ridiculous on numerous occasions. After all, investors need a really strong stomach – or a desperate need for yield – to put money in a debt instrument that can completely be wiped out if the bank goes through a rough patch, even a temporary one. But considering the demand for Barclays’ (NYSE:BCS) CoCo bonds sale this Wednesday, clearly enough investors are yield hungry enough that they will accept these terms.  The largest British bank raised $3 billion through the bonds issue in which it was supported by Citigroup (NYSE:C), Deutsche Bank (NYSE:DB), Credit Suisse (NYSE:CS) and Morgan Stanley (NYSE:MS). The benefit for Barclays is that it’s a source of funding for its balance sheet that won’t throw off its capital requirements.
We maintain a $15 price estimate for Barclays stock, in-line with the current market price.
Barclays, Like Other Banks, Is Looking For Cheap Funding That Does Not Throw Off Capital Ratios
Recently, banks have been exploring options to build on their capital base as they begin shoring up their balance sheets to comply with stricter capital requirements laid out as part of the Basel III norms. And the rather uphill task has forced them to think of out-of-the-box solutions besides the time tested but often inadequate solution of an organization-wide restructuring.
Barclays has been working hard on improving its capital structure – partly under pressure from the U.K.’s financial regulators who are pushing for a ‘ring-fence’ between British banks’ retail & investment banking operations and partly to appease investors who have strongly criticized its business model since it was found guilty of manipulating the LIBOR earlier this year (see Barclays Reorganizes Trading, Banking Units To Appease Investors & Regulators).
Taking a cue from the Swiss banks UBS (NYSE:UBS) and Credit Suisse who saw limited success with CoCo bond issues in the past, Barclays decided to test the waters with the idea of a CoCo bond which was riskier than any issued by a bank. Barclays also aimed for the U.S. debt market, so that it could appeal to a larger investor base than has been done before.
And It May Just Have Found The Perfect Solution For All Its Industry Peers
The terms of Barclays’ CoCo bonds are quite stringent: if the bank’s Common Equity Tier 1 ratio falls below 7% at any time over the 10-year life of the bonds, they will immediately lose their value. In comparison, UBS offered its CoCo bonds at a trigger ratio of 5%, whereas Credit Suisse allowed its bonds to be converted to common equity in the event of a trigger.
But investors hounded the offering nonetheless, with Barclays and the other lead managers booking demand of more than $12.5 billion for the bonds. This allowed the banks to easily place $3 billion worth of CoCo bonds – well above the $2 billion originally planned – at a yield of 7.25% for the ‘BBB-‘ rated debt instrument. It must be noted that 10-year U.S. corporate bonds rated a slightly higher ‘BBB’ yield around 6.25% currently, and the fact that CoCo bonds have a yield just one percentage point above this figure does indicate that Barclays got a good bargain. 
We do believe that the other big banks will come up with similar bond offerings of their own in the months to come. What remains to be seen is how much more of these risky instruments investors are willing to bet their money on.Notes:
- Barclays Selling $3 Billion of Novel CoCo Bonds in U.S., Fox Business, Nov 14 2012 [↩]
- Bond Yields, BondsOnline, 16 Nov 2012 [↩]