Contingent Convertibles (CoCos)

What Are Contingent Convertibles (CoCos)?

Contingent convertibles (CoCos) are debt instruments primarily issued by European financial institutions. Contingent convertibles work in a fashion similar to traditional convertible bonds. They have a specific strike price that, once breached, can convert the bond into equity or stock. The primary investors for CoCos are individual investors in Europe and Asia and private banks.

CoCos are high-yield, high-risk products popular in European investing. Another name for these investments is an enhanced capital note (ECN). The hybrid debt securities carry specialized options that help the issuing financial institution absorb a capital loss.

In the banking industry, their use helps to shore up a bank's balance sheets by allowing it to convert its debt to stock if specific capital conditions arise. Contingent convertibles were created to help undercapitalized banks and prevent another financial crisis like the 2007-2008 global financial crisis.

The use of CoCos has not been introduced in the U.S. banking industry. Instead, American banks issue preferred shares of equity.

Understanding Contingent Convertibles

There is a significant difference between bank-issued contingent convertibles and regular or plain vanilla convertible debt issues. Convertible bonds have bond-like characteristics, paying a regular rate of interest, and have seniority in the case of the underlying business defaulting or not paying its debts. These debt securities also let the bondholder convert the debt holding into common shares at a specified strike price, giving them share price appreciation. The strike price is a specific stock price level that needs to be triggered for the conversion to occur. Investors can benefit from convertible bonds since the bonds can be converted to stock when the company's stock price is appreciating. The convertible feature allows investors to enjoy both, the benefits of bonds with their fixed interest rate, and the potential for capital appreciation from a rising stock price.

Brief Background of CoCos

Contingent convertibles became popular in the investing scene to aid financial institutions in meeting the Basel III capital requirements. Basel III is a regulatory accord outlining a set of minimum standards for the banking industry. The goal was to improve the supervision, risk management, and regulatory framework of the critical financial sector.

As part of the standards, a bank must maintain enough capital or money to be able to withstand a financial crisis and absorb unexpected losses from loans and investments. The Basel III framework tightened the capital requirements by limiting the kind of capital a bank may include in its various capital tiers and structures.

One type of bank capital is Tier 1 capital — the highest-rated capital available to offset bad loans on the institution's balance sheet. Tier 1 capital includes retained earnings — an accumulated account of profits — as well as common stock shares. Banks issue shares to investors to raise funding for their operations and to offset bad debt losses.

Contingent convertibles act as additional Tier 1 capital allowing European banks to meet the Basel III requirements. These convertible debt vehicles allow a bank to absorb the loss of underwriting bad loans or other financial industry stress.

Banks and Contingent Convertibles

Banks use contingent convertibles differently than corporations use convertible bonds. Banks have their own set of parameters that warrant the bond's conversion to stock. The triggering event for CoCos can be the bank's value of Tier 1 capital, the judgment of supervisory authority, or the value of the bank's underlying stock shares. Also, a single CoCo can have several triggering factors.

Banks absorb financial loss through CoCo bonds. Instead of converting bonds to common shares based solely on stock price appreciation, investors in CoCos agree to take equity in exchange for the regular income from the debt when the bank's capital ratio falls below regulatory standards. However, the stock price might not be rising but falling instead. If the bank is having financial difficulty and needs capital, this is reflected in the value of its shares. As a result, a CoCo can lead to investors having their bonds converted to equity while the stock's price is declining, putting investors at risk for losses.

Benefits of Contingent Convertibles for Banks

Contingent convertible bonds are an ideal product for undercapitalized banks in markets across the globe since they come with an embedded option that allows banks to meet capital requirements and limit capital distributions at the same time.

The issuing bank benefits from the CoCo by raising capital from the bond issue. However, if the bank has underwritten many bad loans, it may fall below its Basel Tier I capital requirements. In this case, the CoCo carries a stipulation that the bank doesn't have to pay periodic interest payments, and may even write down the full debt to satisfy Tier 1 requirements.

When the bank converts the CoCo to shares, it may move the value of the debt from the liability side of its balance sheet. This bookkeeping change allows the bank to underwrite additional loans.

The debt has no end date when the principal must return to investors. If the bank falls into financial hardship, it can postpone the payment of interest, force a conversion to equity, or in dire situations, write the debt down to zero.

Benefits and Risks for Investors

Due to their high yield in a world of safer, lower-yielding products, the popularity of contingent convertibles has grown. This growth has led to added stability and capital inflow for the banks that issue them. Many investors buy in the hope that the bank will one day redeem the debt by buying it back, and until they do, they will pocket the high returns along with the higher-than-average risk.

Investors receive common shares at a conversion rate set by the bank. The financial institution may define the share conversion price at the same value as when the debt was issued, the market price at conversion, or any other desired price level. One downside of share conversion is that the share price will be diluted, further reducing the earnings per share ratio.

Also, there's no guarantee the CoCo will ever be converted to equity or fully redeemed, meaning the investor could be holding the CoCo for years. Regulators that allow banks to issue CoCos want their banks to be well-capitalized and as a result, may make selling or unwinding a CoCo position quite difficult for investors. Investors may have difficulty selling their position in CoCos if regulators do not allow the sale.

Real-World Example of a Contingent Convertible

As an example, let's say Deutsche Bank issued contingent convertibles with a trigger set to core Tier 1 capital instead of a strike price. If Tier 1 capital falls below 5%, the convertibles automatically convert to equity, and the bank improves its capital ratios by removing the bond debt off its balance sheet.

An investor owns a CoCo with a $1,000 face value that pays 8% per year in interest — the bondholder receives $80 per year. The stock trades at $100 per share when the bank reports widespread loan losses. The bank's Tier 1 capital falls below the 5% level, which triggers the CoCos to be converted to stock.

Let's say 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 has steadily declined from $100 to $40 over the past several weeks. The 25 shares are worth $1,000 at $40 per share, but the investor decides to hold the stock, and the next day, the price declines to $30 per share. The 25 shares are now worth $750, and the investor has lost 25%.

It's important that investors who hold CoCo bonds weigh the risk that if the bond is converted, they may need to act quickly. Otherwise, they may experience significant losses. As stated earlier, when the CoCo trigger occurs, it may not be an ideal time to purchase the stock.