Germany clears way for more contingent convertibles (CoCo’s)

The German finance ministry has given the countries banks a green light to pursue the issuance of contingent convertible bonds, or CoCo’s, and other contingent capital deals as it clarified the instruments tax treatment.

A report from Reuters states that the German finance ministry has agreed that banks issuing contingent convertibles can deduct interest payment on the bonds from their tax bills. This makes the use of contingent capital as a form of just-in-time capital, or catastrophe insurance, for banks feasible in Germany.

Contingent convertible bonds and other contingent capital issues are similar to catastrophe bonds as they provide a source of capital protection when certain qualifying factors, or triggers, are met. Convertible bonds often convert into equity, so the bond holders see their investments converted into shares and the issuing company benefits from the boost to share capital. Other contingent deals can be written down or even wiped out when the trigger conditions are met.

Some contingent capital deals are linked to bank capital levels, capital ratios, solvency ratios or event to the occurrence of catastrophe losses in the case of a transaction issued by reinsurer Swiss Re. Artemis has covered these transactions a number of times over the years, saying that they are becoming to ‘catastrophe insurance for banks’ as we predicted in our November 2009 article.

The German finance ministry told Reuters; “The finance ministry, together with the federal states, today created legal certainty on the treatment of instruments of banks’ additional core capital, so-called CoCo-bonds. On the basis of existing tax law, banks in Germany can use these instruments with comparable conditions to their European competitors.”

For banks, contingent capital provides a source of tier one capital which it can use within Basel III capital calculations, hence the German banking industry has been keen to see clarity over their tax treatment. Reuters suggests that we could see a flurry of transactions from the major German banks now that contingent convertibles are a more attractive proposition from a tax perspective.

Reuters reports that Deutsche Bank is expected to issue at least $7 billion of additional tier one capital through contingent bonds before the end of next year. Other banks are expected to follow suit to protect their capital ratios. Some reports suggest that globally we could see $150 billion of contingent capital issued in the next few years as banks and other financial institutions look to take advantage of this form of financial catastrophe insurance.

Whether the clarification of the tax treatment of contingent capital bonds might persuade one of Germany’s large reinsurance firms to issue contingent bonds is uncertain. They may be a useful tool for reinsurers like Munich Re and Hannover Re, if they were to structure a contingent deal using a catastrophe trigger in a similar way to Swiss Re’s transaction.

There is some cross-over in the investor base between insurance linked investments (such as catastrophe bonds) and contingent capital or convertible bonds, particularly the fixed income investors. While CoCo’s do not have the useful low-correlation benefits of an investment in pure catastrophe or reinsurance risks, they are attractive due to their potential yield, the binary nature of their trigger and often the (perceived) remoteness of the risk issued when compared to the possible return.