Understanding Contingent Convertibles (CoCos) in European Banking

What Are Contingent Convertibles (CoCos)?

Contingent convertibles (CoCos) are debt securities issued by European banks to strengthen their capital structure. These bonds automatically convert into equity or are written down when a bank’s capital falls below a specified threshold, helping stabilize the institution during financial stress. Designed to meet Basel III capital requirements, CoCos serve as a buffer against potential bank failures. They come with higher yields than traditional bonds but carry a risk of loss of principal or forced conversion.

Deep Dive into Contingent Convertibles (CoCos)

Purpose

CoCos automatically cover bank losses and help meet additional Tier 1 (AT1) and Tier 2 (T2) capital requirements set by Basel III.

Comparing CoCos and Convertible Bonds: Key Differences

There is a significant difference between bank-issued contingent convertibles bonds and standard convertible bonds. Convertible bonds have bond-like characteristics. They pay a regular rate of interest and have seniority in the case of the underlying business defaulting.

These securities allow bondholders to convert them into the issuer’s common stock at a set strike price. This gives investors the potential for share price appreciation. The strike price is a specific stock price that needs to be reached 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. This feature lets investors benefit from fixed interest rates and potential stock price increases.

Unique Features of Contingent Convertibles (CoCos)

CoCos enhance convertible bonds by changing conversion terms. As with the convertible bond, investors receive periodic, fixed-interest payments during the life of the bond. But CoCos automatically create a loss for investors if the issuer’s capital drops under a specific level. If a bank’s capital drops to 7% or 5.125% of risk-weighted assets, it can trigger three outcomess:

• A CoCo being converted to common shares
• A temporary write-down of the CoCo’s value
• A permanent write-down of the CoCo’s value

Triggers can be the price of shares, regulatory capital requirements, or management demands.

The Origins and Development of CoCos

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

Basel III Framework

As part of the standards, a bank must maintain enough capital to be able to withstand a financial crisis and absorb unexpected losses from loans and investments. The Basel III framework tightened banks’ capital requirements by limiting the kind of capital that they could include in their 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.

CoCos act as additional Tier 1 capital (AT1), helping European banks to meet the Basel III requirements. They allow a bank to absorb the loss of underwriting bad loans or other financial industry stress.

Banking Strategies with Contingent Convertibles

Banks use contingent convertibles differently from the way 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.

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.

Importantly, the stock price might be lower than desired when a conversion is triggered. If the bank is having financial difficulty and needs capital, this is reflected in the value of its shares. As a result, CoCos can convert to equity while the stock’s price is declining. This puts investors at risk for losses.

Benefits for Banks

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

2. 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 1 capital requirements. In this case, the CoCo carries a stipulation that the bank doesn’t have to pay periodic interest payments, and it may even write down the full debt to satisfy Tier 1 requirements.

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

4. The security has no end date at which time the principal must return to investors. If the bank experiences financial hardship, it can postpone the payment of interest, force a conversion to equity, or, in dire situations, write the debt down to zero.

Weighing the Pros and Cons of Investing in CoCos

Benefits

• Due to their high yield in a world of safer, lower-yielding products, the popularity of contingent convertibles has grown. Many investors buy CoCos in the hope that the bank will one day redeem the debt by buying it back, and, until it does, they will pocket the high returns and accept 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 as the same value as when the debt was issued, the market price at conversion, or any other desired price level.

Risks

• One downside of CoCo’s share conversion is that the share price will be diluted, further reducing the earnings per share ratio.
• There’s no guarantee that 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.

Real-World Examples of CoCos in Action

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 from its balance sheet.

If an investor owns a CoCo with a $1,000 face value that pays 8% per year in interest, then 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.

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. 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%.

CoCo investors should weigh the risk of needing to act fast if bonds convert to avoid losses. As stated earlier, when a CoCo trigger occurs, it may not be an ideal time to purchase the stock.

CoCos and the Credit Suisse Failure

In 2023, Credit Suisse Group AG’s contingent convertible securities suffered a historic $17 billion loss after UBS Group AG agreed to buy the bank. The Swiss government brokered the deal to contain a spreading crisis of confidence in global financial markets.

The deal triggered a total write-down of CoCos, which provoked an angry reaction from some bondholders. Credit Suisse had 13 CoCo issues outstanding worth a combined 16 billion Swiss francs.

CoCos were designed for crises like these, with known risks.

CoCo bonds of other European lenders also plunged, with Deutsche Bank’s £650 million ($792 million) 7.125% note suffering its biggest-ever one-day decline.

CoCos are a popular way for European banks to raise capital while providing additional loss-absorbing capacity in times of stress. However, Credit Suisse’s experience raised concerns about the future of the CoCo market and AT1 bonds.

While European regulators reiterated that equities should absorb losses before bondholders, the decision to write down the bank’s riskiest debt sparked a furious response from some creditors. It should be noted that most other banks in Europe and the United Kingdom have more protections for their AT1 bonds. Credit Suisse and UBS had language in the terms of their deal that allowed for a permanent write-down.

The Bottom Line

CoCos are debt instruments primarily issued by European banks to strengthen their financial resilience under Basel III regulations. Created after the 2008 financial crisis, they convert into equity automatically when a bank’s capital falls below a certain threshold. This prevents taxpayer-funded bailouts. CoCos typically offer higher yields than traditional bonds, reflecting their greater risk, especially for potential losses if conversion is triggered during financial distress. While they can stabilize banks’ capital structures, their complexity and risk make them suitable only for investors who fully understand their mechanics and potential downsides.