Watchdog to keep an eye on impact of convertible bonds

Spain’s National Stock Exchange Commission (CNMV) says that it will be paying “special attention” to tax breaks that companies try to give themselves when presenting their annual accounts. In a statement issued this week on the supervision of annual financial reports by companies traded on the Madrid stock exchange for 2012, the CNMV said that among its priorities for the coming financial year will be making sure that new rules published last month setting out how debt securities can be used to bolster banks’ capital are observed.

The CNMV said that among its other priorities for 2014 will be the new breed of bank debt that turns into equity if a lender hits trouble. The instruments, known as “contingent convertibles,” began to get attention following the financial crisis and have been issued by a few banks. CoCos, as they are called, are sold as interest-bearing debt that has to be paid back. But they convert to equity in the event that a bank’s capital ratios fall below certain levels.

CoCos boost the capital ratios of banks not healthy enough to attract private investment. Capital ratios are an important measure of financial health, and many European banks this year struggled to increase those ratios to comply with new European regulations. The CNMV said that the 2008 financial crisis underlined that many debt securities banks had counted as capital couldn’t absorb losses outside of a default, prompting regulators to tighten the rules for what can be Tier 1, the most junior layer of capital. While that must consist of equity and retained earnings, lenders can also hold additional securities specifically designed to absorb losses in a crisis.

Bond buyers have shown they are willing to buy CoCos as central banks print money to hold down rates, forcing investors to take more risk to get a return. CoCos absorb losses either by converting to equity or by being written down.

Investors and banks have been skeptical about CoCos, concerned that as the bonds reach their conversion point, equity investors might see that as a bad sign and flee, sending the bank into a downward spiral.

The CNMV also says that it will be imposing measures to guarantee transparency and comparability relating to all information given on financial instruments, and that this would require companies to improve the quality of their annual reports.