Contingent convertibles (CoCos) are debt instruments primarily issued by European financial institutions. These securities operate similarly to traditional convertible bonds with a specific trigger price that, once breached, allows for the conversion of bonds into equity or stock.
CoCos, also known as AT1 bonds or enhanced capital notes (ECNs), are high-yield, high-risk products. These hybrid debt securities carry specialized options that enable financial institutions to absorb capital losses.
How CoCos Strengthen Financial Institutions
CoCos can shore up a bank’s balance sheets by converting debt into stock under specific unfavorable capital conditions. They were innovated after the 2007–2008 global financial crisis to support undercapitalized banks and reduce the potential for taxpayer-funded bailouts.
Key Insights:
- CoCos have a strike price at which the bond can be converted into stock.
- They automatically absorb losses and satisfy regulatory capital requirements.
- Struggling banks can benefit by deferring bond repayments, interest payments, or converting bonds to stock.
- CoCo investors typically enjoy higher interest payments than those from traditional bonds.
In-depth Look at Contingent Convertibles
The Purpose of CoCos
CoCos are designed to automatically cover the losses of a bank and assist them in meeting additional Tier 1 (AT1) and Tier 2 (T2) regulatory capital requirements set by Basel III.
Comparing CoCos with Convertible Bonds
Convertible bonds have bond-like characteristics. They pay regular interest and have seniority in case of default. These bonds can be converted into the issuer’s common stock shares at a specific strike price, providing potential for share price appreciation.
CoCos differ from convertible bonds by modifying conversion terms. Reaching thresholds (normally, 7% or 5.125% of total risk-weighted assets) can lead to conversion to common shares or temporary/permanent write-downs of CoCos’ value.
As of 2019, CoCos had not been introduced in the U.S. banking industry.
History and Impact of Basel III on CoCos
Basel III Framework
Basel III imposes minimum capital standards on banks to enhance supervision, risk management, and regulatory frameworks. Such standards include maintaining enough capital to endure financial crises and absorb unexpected losses.
As additional Tier 1 capital (AT1), CoCos help European banks meet Basel III requirements, allowing them to absorb the losses of underwriting bad loans.
Utilization of CoCos by Banks
Banks Deal with Financial Loss
Banks leverage CoCos selectively under parameters like Tier 1 capital value or supervisory authority judgment. Instead of relying solely on stock price appreciation, CoCo investors accept equity instead of the periodic income when regulatory standards are unmet.
Bank Benefits:
- Embedded option allowing banks to meet capital requirements and limit capital distributions.
- Ability to raise capital from bond issues while potentially adhering to Basel Tier 1 requirements without paying periodic interest payments.
- Banks can remove the debt value from liabilities upon conversion to shares, allowing underwriting of additional loans.
- No definitive end date necessitating the principal’s refund—interest payment postponements or forced conversions serve as alternatives.
Weighing Benefits and Risks of CoCos for Investors
Benefits:
- High-yielding CoCos are popular in high-risk investment portfolios.
- Investors exploit the hope of CoCos conversion into equity, often enjoying higher returns.
- Some conversions offer favorable conversion prices to receiving common shares.
Risks:
- Unsure share conversion prices may dilute earnings per share.
- Uncertain conversion/redeemability lead to prolonged investments in CoCos.
- Selling CoCos may prove a challenge due to regulatory constraints.
Pros and Cons
Pros:
- Facilitates raising Tier 1 capital for European banks.
- Permits flexibility in interest payment schedules, enabling avoidance of debt payments where necessary.
- Investors benefit from periodic high-yield interest payments.
- Positive triggers (price appreciations) benefit investors in converted shares.
Cons:
- Risk and decisions about conversions are less controlled by investors.
- Conversions occurring during stock price declines increase investor losses.
- Certainty of position liquidation remains questionable.
- Higher interest/payment risk makes CoCos costlier compared to traditional bonds.
Real-World Example of a CoCo Event
Suppose Deutsche Bank issued CoCos with a core Tier 1 capital trigger set at 5%. A fall below this threshold transforms CoCos to equity, enhancing the bank’s capital ratio.
For instance, an investor with a $1,000 face value CoCo paying 8% interest earns $80 annually. If share price crashes from $100 to $40 amid loan loss reports, conversion from CoCo results in decreased valuation—25 converted shares worth $1,000 at $40 per share may later drop to $30 per share, causing investor loss.
Investors should act swiftly during conversions, mindful of drastic potential valuation drop.
Spotlight: Credit Suisse’s 2023 Failure
Lesson from Credit Suisse’s Crisis
In 2023, Credit Suisse’s contingent certificate collapse resulted in a $17 billion loss upon UBS Group AG’s takeover. The crisis reconfirmed an agreed total CoCo debt write-down, infuriating bondholders amid traditional focus on equitability prioritizing bondholder protection.
Other European lenders faced contagion depreciating bond values, and questions on long-term solvency strengthened regulatory reassurances.
Contrasts and Repercussions – CoCos vs. Convertible Bonds
Despite functional similarities, CoCos bear extensive triggers and heightened regulation deducting or converting based on solvency demands and offering lucrative interest as a trade-off unlike simpler convertible bonds favoring holder seniority in business defaults.
Conclusory Thought on CoCos during Financial Unrest
Periods of financial volatility deepen risks for CoCo investors—the onus lies in proactive management towards conditions breaching capital restrictions that may halt interest or enforce conversion under deteriorating market conditions. Patience navigating chaotic economic climates tests investor resilience as regulatory enforcements further shape CoCo landscape.
Consigning due diligence maneuvers CoCo investments amidst daunting financial exigencies packs imperative portfolio strategies intertwining substantial yield aspirations against measured reception of systemic crises.
Related Terms: Convertible Bonds, Capital Requirements, Tier 1 Capital, Financial Crisis, Basel III.
References
- Nuveen. “Understanding contingent capital securities (CoCos)”, Download complete PDF.
- U.S. Securities and Exchange Commission. “Eligibility of Contingent Convertible Capital Securities for an Offering Under Rule 144A”, Page 2.
- Bank for International Settlements. “Basel III: International Regulatory Framework for Banks”.
- Basel Committee on Banking Supervision. “Basel III: Finalising Post-Crisis Reforms”.
- FDIC. “Are Contingent Convertibles Going-Concern Capital?”
- Bank of International Settlements. “CoCos: A Primer”, PDF Pages 44-45.
- Fortune. “Credit Suisse’s $17B of risky bonds now worthless after takeover by UBS: ‘Those bonds were created for moments like this’.”
- Bloomberg. “Banks’ Riskiest Bonds Sink as Credit Suisse Wipeout Jolts Market”.
- The Straits Times. “Wipeout of Risky Credit Suisse Bonds Upends $369 Billion Market”.
