Contingent Convertibles (CoCos)

What are contingent convertibles?

Contingent convertibles (CoCos), also known as AT1 bonds, are hybrid securities primarily issued by European financial institutions. These debt instruments serve a critical role in meeting regulatory capital requirements set forth by regulators such as the Basel III framework, particularly in the aftermath of the 2007-2008 financial crisis. CoCos function similarly to traditional convertible bonds but come with specialized features designed to bolster a bank's regulatory capital ratios.

In essence, CoCos act as a buffer for financial institutions, providing a mechanism to absorb losses in times of financial stress or market turmoil. They offer a unique solution for banks to enhance their capital structures and manage risk effectively.

Contingent convertibles explained

Contingent convertibles represent a unique class of hybrid securities within the banking industry. These instruments are strategically crafted to meet regulatory capital requirements, particularly the standards set forth by Basel III regulations in Europe. Under Basel III guidelines, financial institutions are required to maintain certain capital ratios to ensure stability and resilience in the face of economic challenges. CoCos play a crucial role in helping banks meet these regulatory capital requirements, particularly in the realms of Additional Tier 1 (AT1) and Tier 2 (T2) capital.

The distinguishing feature of contingent convertibles lies in their contingent nature, as the name suggests. Unlike traditional convertible bonds, where conversion into equity is solely at the discretion of the bondholder, CoCos incorporate predefined triggers or threshold levels. These triggers are activated in the event of a predefined trigger event, such as a significant decline in the issuer's capital reserves.

When such trigger events occur, contingent convertibles undergo an automatic conversion or write-down, thereby converting a portion of the debt into equity or absorbing losses to strengthen the issuing bank's capital position. This unique mechanism ensures that CoCo holders bear a share of the risk alongside other stakeholders, including shareholders and creditors.

Moreover, the CoCo issuances provide investors with higher interest rates compared to traditional bonds, compensating for the added risk associated with potential loss absorption. These hybrid securities offer a balance between risk and reward, attracting investors seeking higher yields while contributing to the stability of the banking sector.

Why are CoCos attractive?

Contingent convertible bonds hold significant appeal to investors due to their unique characteristics and potential for higher returns. These hybrid securities offer higher interest rates compared to traditional bonds, providing investors with an opportunity to earn increased yields on their investments. The fixed-rate nature of CoCo bonds ensures a steady stream of income for investors throughout the life of the asset, with pre-established coupon payments guaranteed from the moment of issuance until any forced conversion event occurs.

Moreover, the contingent conversion feature of CoCo bonds presents investors with the possibility of capital appreciation if the underlying shares perform favorably. In other words, when CoCo bonds convert into equity, investors stand to benefit from any positive movement in the stock price over the long term. This potential for greater profit adds to the attractiveness of CoCo bonds as an investment option in the financial markets.

How banks use CoCos?

Banks leverage contingent convertible bonds in a distinct manner compared to how corporations utilize convertible bonds. These financial institutions adhere to specific parameters dictating the conditions under which the bonds convert into stock. The triggering event for CoCos can be tied to various factors such as the bank's Tier 1 capital value, regulatory assessments, or the performance of the bank's underlying stock shares.

The primary function of CoCos for banks is to serve as a mechanism for absorbing financial losses. Unlike traditional convertible bonds, where conversion is driven solely by stock price appreciation, CoCos entail investors agreeing to receive equity in exchange for the regular income generated from the debt instrument when the bank's capital ratio dips below regulatory standards.

It's essential to note that the conversion of CoCos into equity may occur even if the stock price is not favorable at the time of triggering. In situations where a bank encounters financial challenges and requires additional capital infusion, the value of its shares may be depressed. Consequently, CoCos can convert into equity during periods of declining stock prices, exposing investors to potential losses.

Benefits and risks of investing in CoCos

Benefits

1. High Yield. CoCos offer attractive returns, providing investors with higher yields compared to safer, lower-yielding products available in the market. This increased yield serves as a significant draw for investors seeking to optimize their returns in a low-interest-rate environment.

2. Potential for Redemption. Investors in CoCos often anticipate the eventual redemption of the debt by the issuing bank. Until redemption occurs, investors benefit from the high returns generated by CoCos, thereby maximizing their income potential.

3. Conversion to Equity. Upon triggering the conversion event, investors receive common shares at a predetermined conversion rate set by the bank. The conversion price can be determined based on various factors, including the market price at conversion or a specific value specified by the financial institution.

Risks

1. Dilution of Share Price. One inherent risk associated with CoCos is the dilution of the share price upon conversion. This dilution can adversely affect the earnings per share ratio, potentially impacting shareholder returns and overall investment performance.

2. Uncertainty of Conversion. There is no guarantee that CoCos will be converted to equity or fully redeemed, leading to uncertainty for investors. This uncertainty may result in investors holding CoCos for extended periods without realizing their desired outcomes.

3. Regulatory Constraints. Regulators overseeing the issuance of CoCos prioritize the well-capitalized status of banks. Consequently, regulatory requirements may make it challenging for investors to sell or unwind their CoCo positions, potentially limiting liquidity and flexibility in managing investments.

CoCos vs. Convertible bonds

1. Triggers for Conversion. CoCos have multiple triggers that can initiate the conversion of the bond into equity, such as specific capital thresholds or regulatory requirements. In contrast, traditional convertible bonds typically have a single trigger based on the stock price reaching a predetermined level.

2. Interest Rates. CoCos generally offer higher interest rates compared to convertible bonds to compensate investors for the additional risks involved. These risks stem from the unique features of CoCos, such as their contingent conversion mechanism designed to help banks absorb capital losses.

3. Priority in Default. In the event of default by the issuing entity, convertible bondholders usually have priority over CoCo holders. Convertible bonds often carry seniority, providing bondholders with a higher claim on assets compared to CoCos, which are considered secondary debts issued by banks.

4. Issuing Entities. CoCos are primarily issued by banks as part of their capital management strategy to strengthen their financial position and meet regulatory requirements. On the other hand, convertible bonds are commonly issued by corporations seeking to raise capital for business expansion or investment projects.

Are CoCos regulated?

CoCos are subject to regulation, particularly in the European Union (EU), where they fall under the purview of the Basel III regulatory framework. This framework establishes minimum standards for the banking industry, aiming to enhance supervision, risk management, and capital adequacy.

Under Basel III regulations, financial institutions issuing CoCos are required to adhere to specific guidelines regarding their issuance, management, and reporting. These regulations are designed to ensure the stability and resilience of the financial system by mitigating risks associated with complex financial instruments like CoCos.

Additionally, national regulatory authorities, such as the Swiss government, may impose additional requirements or guidelines governing the issuance and trading of CoCos within their jurisdictions. These regulations aim to protect investors, maintain financial stability, and uphold the integrity of the financial markets.

Example

Let's consider an example involving Deutsche Bank issuing contingent convertible bonds (CoCos) with a trigger set to core Tier 1 capital instead of a strike price. If the Tier 1 capital falls below a certain threshold, let's say 5%, the CoCos automatically convert to equity, thereby improving the bank's capital ratios by removing the bond debt from its balance sheet.

Imagine an investor holds a CoCo with a face value of $1,000 that pays an annual interest rate of 8%. This means the bondholder receives $80 per year in interest payments. Now, let's assume the bank encounters widespread loan losses, causing its stock price to decline from $100 per share to $40 per share.

As a result of the deteriorating financial condition of the bank, its Tier 1 capital falls below the 5% threshold, triggering the conversion of the CoCos into stock. The conversion ratio allows the investor to receive 25 shares of the bank's stock for the $1,000 investment in the CoCo.

However, the stock price continues to decline, reaching $30 per share the next day. As a result, the 25 shares received from the conversion of the CoCo are now worth $750 in total. In this scenario, the investor experiences a loss of 25% on their investment.

It's crucial for investors holding CoCo bonds to carefully assess the risks involved, including the need to act swiftly in response to conversion triggers. Failure to act promptly could result in significant losses, especially if the conversion occurs during a period of declining stock prices.

Some examples of Contingent Convertibles are: Barclays Bank PLC, 7.625% 21nov2022, USD, Credit Agricole SA, 8.125% 19sep2033, USD, Credit Suisse Group AG, 7.5% perp., USD.