Explanation:
D is correct. Because CoCos are debt instruments when issued, holders receive little or none of the high returns received by equity holders when a bank does well, but bear losses not so different from those of equity holders when a bank fails. Thus, they should be expensive for a bank to issue. But they do have an accounting advantage: because they do not appear in the equity account until converted, a bank can report a higher return on equity.
A is incorrect. CoCos cause a bank’s equity to increase when distress occurs, as reflected by triggers written into the indenture, and not at the option of the holder. With CoCos, equity increases either because the bond converts to equity or because its value is written down.
B is incorrect. CoCos are debt instruments that can be converted into equity and not at the option of the holder.
C is incorrect. CoCos can qualify as either Additional Tier 1 or Tier 2 capital, depending on the particular security structure. A common CoCo trigger is when the ratio of Core Tier 1 Capital to RWA falls below a threshold, or when a bank’s primary regulator declares it to be nonviable. CoCos may be included in Additional Tier 1 Capital if the threshold is 5.125 percent or higher, and Tier 2 capital otherwise.
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A
CoCos give their holders the option to convert them into the equity of the issuing bank either before maturity or at maturity, depending on the type of CoCo.
B
CoCos give their holders the option to convert their medium- or long-term debt to short-term debt if certain interest rate conditions specified in the indenture are met.
C
CoCos may be included in Tier 2 capital but not in Tier 1 or Additional Tier 1 capital due to the risks they pose to the issuing bank and the difficulties in pricing them.
D
CoCos can be more expensive for banks to issue than equity, but they allow the issuing bank to report a higher return on equity until they are converted.