What Are Contingent Convertibles (CoCos)?

What Are Contingent Convertibles (CoCos)?

Let me explain contingent convertibles, or CoCos, directly to you. These are debt instruments mainly issued by European financial institutions, functioning somewhat like traditional convertible bonds. They come with a specific strike price that, once hit, triggers conversion of the bond into equity or stock.

You should know that CoCos, also called AT1 bonds, are high-yield, high-risk products. They're sometimes referred to as enhanced capital notes (ECNs). The key here is their specialized options that let the issuing bank absorb capital losses. CoCos strengthen a bank's balance sheet by allowing debt-to-stock conversion under unfavorable capital conditions. They emerged after the 2007–2008 global financial crisis to support undercapitalized banks and avoid taxpayer-funded bailouts.

Understanding CoCos

CoCos have a strike price where the bond converts to stock. They're tools for banks to absorb losses automatically and meet regulatory capital requirements. If a bank is in financial trouble, it doesn't have to repay the bond, pay interest, or even convert it to stock. Investors get interest payments that are usually much higher than those on traditional bonds.

Purpose and Comparison to Convertible Bonds

CoCos are built to cover bank losses automatically and help satisfy additional Tier 1 (AT1) and Tier 2 (T2) capital requirements under Basel III. Unlike standard convertible bonds, which pay regular interest and have seniority in defaults, CoCos modify conversion terms. Convertible bonds let you convert to common stock at a strike price for potential share appreciation, combining fixed interest with capital gains.

With CoCos, you get periodic fixed-interest payments, but if the issuer's capital drops below levels like 7% or 5.125% of risk-weighted assets, it can lead to conversion to shares, temporary write-down, or permanent write-down. Triggers can include share prices, regulatory needs, or supervisory demands.

Background of CoCos

CoCos gained popularity to help meet Basel III capital requirements, which set minimum standards for banking supervision, risk management, and frameworks. Basel III tightens capital needs to withstand crises and absorb losses. Tier 1 capital includes retained earnings and common stock, and CoCos count as additional Tier 1 capital for European banks, absorbing losses from bad loans or stress.

How Banks Use Contingent Convertibles

Banks trigger CoCo conversions based on Tier 1 capital, supervisory judgment, or stock values. They absorb losses by converting debt to equity when capital ratios fall below standards, potentially at declining stock prices, putting you at risk. For banks, CoCos raise capital, allow postponing interest or writing down debt, remove liabilities from balance sheets, and have no maturity date.

Benefits and Risks of CoCos for Investors

You benefit from high yields, hoping for redemption while accepting risks. Conversion gives shares at a set rate, but it dilutes share prices and earnings per share. There's no guarantee of conversion or redemption, and regulators might make selling difficult. Banks pay higher interest than traditional bonds, but you bear conversion risks, especially if shares decline.

Examples of a Contingent Convertible

Consider Deutsche Bank issuing CoCos with a 5% Tier 1 trigger. If capital falls below, they convert to equity, removing debt. An investor with a $1,000 CoCo at 8% gets $80 yearly, but conversion to 25 shares at $40 (down from $100) could lead to losses if the price drops further to $30, resulting in a 25% loss. You need to act quickly on conversions to avoid significant hits.

CoCos and the Credit Suisse Failure

In 2023, Credit Suisse's CoCos saw a $17 billion write-down after UBS's acquisition, brokered by the Swiss government. This hit bondholders hard, with 16 billion Swiss francs in issues affected. Other banks' CoCos dropped too. While designed for crises, this raised concerns about the CoCo market, though most European banks have better protections.

FAQs

How do CoCos differ from convertible bonds? CoCos have multiple triggers and higher risks, helping banks absorb losses, while convertibles prioritize holders in defaults. Are CoCos regulated? Yes, under EU Basel III for capital standards. What happens in a crisis? CoCo values can plummet; banks may postpone payments, convert at low prices, or write down to zero.

The Bottom Line

CoCos are debt instruments from European banks convertible to stock at strike prices, shoring up Tier 1 sheets and absorbing losses. They're high-yield but high-risk, so weigh them carefully if you're considering investment.