In 2014, financial institutions in Québec began issuing NVCC (Non-Viability Contingent Capital) instruments, which include CoCo (Contingent Convertible) bonds.
What are NVCC instruments?
NVCCs are hybrid financial instruments. They have the traits of both debt and equity securitiesAn equity security, or participating security, is a security that entitles you to an ownership interest in a company. Common shares and preferred shares are equity securities.
A person who holds 10% of a company’s equity securities owns a 10% interest in that company.
When a company ceases to operate, the proceeds from the sale of its assets are used to pay its debts and taxes, and the rest of the money is distributed to holders of equity securities (shareholders).
The company can distribute a portion of its earnings to holders of equity securities by paying them dividends.
The equity securities of companies listed on an exchange are bought and sold at the exchange.. Convertible bondsA convertible bond is a bond that the holder may convert into common shares. are the most common form of hybrid instruments.
CoCos (contingent convertibles) are a special category of convertible bonds. They have a protective mechanism that converts them into common shares when a trigger event threatens an institution’s viability. A trigger even may occur if a financial institution does not have the cash required to meet its commitments.
The only authorized protective mechanism is conversion into common shares.
In Canada and Québec, only the Office of the Superintendent of Financial Institutions (OSFI) and the AMF, respectively, have the authority to decide whether a financial institution is or is about to become non-viable.
What is the difference between CoCos and traditional convertible bonds?
A traditional convertible bond gives the holder the right to exchange the asset for common shares at particular periods and at a certain rate.
In Canada, CoCos will automatically be converted following a decision by OSFI or the AMF.
Take time to read the prospectus and ensure that you understand the conditions for conversion.
Before investing, make sure that you understand the products and choose investments that fit with your investor profile.End of the warning
Why do financial institutions issue this type of instrument?
In response to the 2008 financial crisis, the Basel III Accord now requires banks to be more resilient by strengthening their capital base (Tier 1 capital, consisting of funds raised through the issue of common shares, and retained earnings).
As a direct consequence of the options available to banks through Basel III, NVCC instruments were created to gradually improve capital ratios by issuing low-cost quasi-equity instruments.
What are the advantages of NVCCs?
For investors, these products offer higher returns than do government or corporate bonds in a low-interest environment.
What are the risks?
- NVCC instruments are complex.
- NVCC instruments are recent products and associated risks may not be fully understood.
- When a trigger event occurs, the viability and future of the financial institution are uncertain. Investors might then find themselves holding securities with little value.