Contingent Convertible Bonds
Contingent convertible bonds, often referred to as CoCos, are securities issued by banks to meet regulatory capital requirements. They are complex, hybrid instruments and highly risky. Trading contingent convertible bonds is unfortunately not a simple game, but our guide will cover all the basics. We explain how contingent convertible bonds work using examples, list their benefits and risks, plus share tips on getting started for traders.
What Are Contingent Convertible Bonds?
Contingent convertible bonds, also known as CoCos, are debt securities that are converted into equity if a specified event occurs. If the trigger is breached, the automatic conversion of debt creates new equity allowing the issuer to improve its capital structure. The bonds are primarily issued by financial institutions.
The concept was proposed in 1990 as a guarantee that gives shareholders ‘contractual right to seize a firm’s assets whenever the value of these is below the guaranteed debt’. Importantly, contingent convertibles were developed to help undercapitalized banks and prevent another financial crisis similar to the 2007-2008 global financial crash.
According to Bloomberg, many investors are sceptical that the extra yield CoCos offer reflects their dangers. Nevertheless, about 200 issues worth over 180 billion Euros have been purchased since they first came available in 2013. These purchased CoCos are used to raise what is known as Additional Tier 1 (AT1) capital. This is a lender’s first real line of protection after equity against significant financial shocks.
Contingent convertibles became popular in the investing scene to aid financial institutions in meeting the Basel 3 capital requirements. This is a regulatory authorization, defining principles for the financial industry. The goal was to progress supervision and apply relevant risk management and a regulatory framework for the banking sector.
The Basel III proposals were transposed into EU law through the Capital Requirements Directive IV (CRD IV) and Capital Requirement Regulation (CRR). The EU law states the total amount of capital an institution needs to issue as a percentage of risk-weighted assets (RWA) is 8%. The implemented legislation mandates a change in the quantity of the highest quality capital layer Common Equity Tier 1 (CET1), increasing from what was effectively 2% to 4.5%.
While the legislation intends to ensure an increase in a bank’s common equity, the regulation allows a financial institution to issue Additional Tier 1 (AT1) securities in non-CET1 capital but in the form of CoCos, so that Tier 1 capital is at least 6% of RWA at all times. CoCos may also be issued as Tier 2 instruments so that total capital is at least 8% of RWA at all times.
Avdjiev et al. provide some interesting figures based on a study of CoCo bonds. Initial placement data suggests private banks and retail investors hold over 50% of CoCos in the trading environment, with the remaining split between hedge fund pools, asset management companies and insurance organizations.
Between 2009 and 2015, banks around the world issued a total of $446.958 billion in CoCos through 519 different issues. Of these, 44.6% were issued in the US Dollar, 18% in Euros and the rest in other currencies.
How CoCos Work
Banks use contingent convertibles differently than financial corporations use standard convertible bonds. Banks have pre-defined triggers that permit the bond’s conversion to stock. Like standard convertible bonds, these perpetual subordinated instruments contain specific triggers that detail the conversion of debt holdings into common stock. There is a range of factors that can play into this conversion, and it sometimes even covers several combined events. Examples include the value of the bank’s shares, demands from their regulatory authority or the financial institution’s value of tier one capital.
Trading contingent convertible bonds is often a long-term investment strategy. The process can involve a wait of sometimes 6 months to 5 years. There is also no assurance that the contingent bond volume will ever be converted to equity or fully redeemed.
The conversion process is activated when a specific identifier breaches a certain level. The bonds have two defining characteristics; a trigger that activates conversion and a loss-absorbing mechanism that specifies how the losses are absorbed at conversion.
Under Basel III, a bank’s capital is categorized into three levels; CET1, Additional Tier 1, and Tier 2 capital. Upon the incidence of a trigger event, the issues may either convert the contingent convertible bonds into a number of shares at a conversion ratio and price or temporarily or permanently write off the principal amount of the contingent convertible security.
In most CoCos, traders will be rewarded with ‘coupons’ over a period stated by the issuer. This may be monthly, quarterly or annually. These funds will be paid up until the date of bond maturity, the date that the trigger event occurs and bond conversion happens, the date the CoCo is written off, or the date on which the issuer exercises a call option to redeem the contingent convertible securities.
It can be much easier to visualize trading contingent convertible bonds with a detailed example…
Let’s say Barclays Bank PLC released contingent convertible bonds with a trigger set to core tier one capital in the place of a strike price. If the tier one capital falls below 5%, the convertible bonds will instinctively convert to equity, and the bank recovers its capital ratios by removing the bond debt from its balance sheet. As a reminder, tier 1 capital is the highest quality regulatory capital, which should be capable of absorbing a firm’s losses. It is intended to ensure that a company preserves sufficient capital to absorb unexpected losses as well as to fund ongoing activities.
As a trader, let’s say you own a contingent convertible bond with a $1,500 value. The stock trades at $60 per share when Barclays reports cash flow issues, causing the tier one capital level to fall below 5% and triggering the CoCo to be converted to stock.
Imagine that the conversion ratio lets the investor trading contingent convertible bonds to receive 20 shares of Barclays stock (ticker symbol BARC) in return for a $1,500 investment in the bond. However, as the bank has experienced issues, the stock has seen a decrease in value from $60 to $30 across a few weeks. The 20 shares are now worth $1,500 at $30 per share. The 20 shares are now worth $600, and the trader has lost 40%.
Note, when a bond issuer chooses to convert the contingent convertible bonds into shares, the number of shares received by investors will be determined by a conversion ratio and the price calculated based on certain variable components. This can include a predetermined minimum price, a reference market price and a nominal value of the underlying shares of the issuer.
This example highlights the importance of acting quickly when a bond is converted. Significant losses may be experienced if the share price continues to decrease in value.
Trading contingent convertible bonds in a portfolio involves deciding some key structure points such as the maturity, levels of trigger and conversion rate. Unfortunately there is no simple formula to help you determine the exact moment of conversion. These factors will, however, all contribute to determining the book value of the security.
Trigger methods can be grouped into three major categories:
- Market-Based Trigger – This format uses a company’s share price as the trigger variable. It is the most transparent method when it comes to modelling conversion and monitoring historic and potential upcoming price movements
- Capital-Based Trigger – When trading contingent convertible bonds, a capital-based trigger eliminates some of the uncertainty from a regulator’s decision. Essentially it uses an accounting treatment ratio to indicate the viability of a bank
- Regulator-Based Trigger – Regulators have the authority to decide when and how to convert. These organizations have full control and often may delay conversions, particularly if they believe the event will be short-lived. It can be particularly difficult for investors to model given the lack of a clear pattern
As well as understanding the specific types of triggers, the level of trigger will determine the nature of the underlying security. For example, CoCos that have a high trigger (close to the level) are expected to convert quicker vs those with a low trigger. If you are looking to invest in a high-trigger CoCo, be prepared to pay a higher price due to their increased likelihood of conversion.
Let’s view some scenarios below, assuming the below factors are consistent throughout…
- Coupon Rate – 6% per year
- Term – 30-year fixed investment terms
- Price of CoCo At The Time Of Purchase – $500
We outline a few different outcomes that could occur after the initial investment:
A Trigger Event Occurs After One Year And Bonds Are Converted To Shares
- The investor would have gained $30 from coupon payments (6% of $500)
- A conversion ratio and price will be determined according to pre-set rules set out by the issuer
- The investor will receive an equivalent number of shares based on the conversion price and rate
- Depending on the conversion rate and price, a profit or loss will be made
A Trigger Event Occurs After One Year And The Issuer Writes Off 30% Of The Face Value Of The Bonds
- The investor would have gained $30 from coupon payments (6% of $500)
- Likely to have a negative result for investors with a loss which is equal to or greater than 24% of the initial investment (30% write-off minus 6% coupon rate)
The Investor Sells The Bonds
- After one year, the investor can sell the contingent convertible bonds at the price of $500
- During this year, the investor earns 6% from coupon payments
- A realized profit on a margin of 6% is made
But no matter which scenario plays out, trading contingent convertible bonds is a risky strategy.
Pros Of Trading Contingent Convertible Bonds
- Increased Stability – As the popularity of the trading instrument grows, the market has seen increased stability and capital inflow for the issuing banks. Investors can benefit from the yield returns, in the hope that one day the bank will redeem the debt
- High Yield – Trading contingent convertible bonds has a rising interest due to their high yield potential. At the start of 2019, most CoCo bonds had a coupon return rate of between 6-9% with yields continuing to attract investors with ongoing low-interest rates
Cons Of Trading Contingent Convertible Bonds
- Capital Hierarchy Favours Equity Holders – In some instances, investors trading contingent convertible bonds may suffer loss ahead of equity holders
- Commitment – It is a long-term strategy, which in some cases may never complete. It should be worth noting that once a bond has been purchased, it may be difficult to sell a position if regulators do not permit it
- Varied Trigger Levels – Conversion risk depends on the CET1 distance to the trigger level. Some issuers may not provide the transparency required to mitigate risks, importantly an ongoing understanding of the amount of CET1 in place relative to the trigger level
- Knowledge Requirement – Trading contingent convertible bonds is no simple task. To be successful, in-depth knowledge of the issuing bank and regulatory guidance is needed. And most importantly, an understanding of the scenario in which a bond may be converted to equity or coupons cancelled
- Discretionary Payments – Coupon payments on AT1 instruments are entirely discretionary and may be cancelled by the issuer at any point, for any reason, and for any length of time. AT1 CoCos have high call-extension risk, callable at predetermined levels only with the approval of the competent authority, meaning some investors may never receive a return
How To Get Started
Trading contingent convertible bonds isn’t quite as simple as investing in stocks, currencies or commodities. Individual bonds should be purchased through a broker that has a bond desk that specializes in convertible markets.
Understand Eligibility In Your Country Of Residency
Due to the high-risk nature of trading this type of bond, there are restrictions. You should spend some time understanding the levels of authorization, protection and associated risks when it comes to this asset type. The process of trading contingent convertible bonds and applicable tax treatments will vary between countries. For example, the use of CoCos has not been introduced in the US banking industry, therefore retail investors will not find the instrument for sale. In its place, American banks issue preferred shares of equity.
Find A Brokerage
Secondly, you will need to find a broker that supports the product and strategy. The list of brands that enable the purchase of bonds, such as CoCos includes Vanguard, Fidelity, IG, Interactive Brokers and IC Markets. You can find plenty of information on these established brokers’ websites to answer key questions such as how to buy and sell bonds, the pros and cons of the asset, plus how to understand the write-off price.
The best brokers provide unlimited access to educational resources including step-by-step guides, online glossary books, the latest market news and historical price analysis.
Study The Market
An online search can help you understand trigger levels and the current performance of the bank. Popular sites include Yahoo Finance and TradingView. YouTube also has a wealth of accessible video content with posts including previous case study analysis, brief introductions to bonds for beginners and understanding how companies use the instrument for fundraising and capital structure decisions. Other well-regarded market research tools include studying company newsletters or articles or viewing their latest financial journey entry.
Despite the significant amount of information available, it is still tricky to understand whether CoCos are a good or bad investment. The potential for conversion is not an easy prediction with many other factors feeding in.
Risks & Regulations
Trading contingent convertible bonds can seem an exciting prospect, however, it is not risk-free. In 2014, the European Securities and Markets Authority (ESMA) issued risk guidance when trading this type of bond. They quote ‘investors should fully understand and consider the risks of CoCos and factor these into their understanding of value. Investors should understand the probability of activating the trigger, the extent and probability of losses upon trigger conversion (from a write-down or unfavourable timed conversion) and the likelihood of the cancellation of coupons’.
In 2015, trading contingent convertible bonds were permanently banned for UK investors by the FCA. The decision was made following concerns around the complexity of investor access, plus understanding the price of CoCos. ‘High-risk, high-yield, CoCo are in strong demand, as ”investors are throwing caution to the wind, taking more risk to get that extra return, raising the question whether risk is correctly priced’, Financial Times 2017.
Comparisons To Other Types Of Bonds
Trading contingent convertible bonds is a complex strategy. Classified under the hybrid category, it combines the characteristics of various other securities such as an equity security, a debt security, a commodity, and/or a derivative.
Trading Contingent Convertible Bonds Vs Convertible Bonds
By definition, trading contingent convertibles are similar to traditional convertible bonds in that there is a strike price. This is essentially the cost of the stock when the bond converts. The main difference is that there is an additional threshold to the strike price, triggering the conversion when specific conditions are met.
Standard convertible bonds are bonds issued by a company that can be converted into its shares at the choice of the bondholder. When trading contingent convertible bonds, these will only be converted into shares once the event happens and the alert triggers. CoCos are designed as loss-absorbing instruments that can be converted into shares when the company is under capital distress.
Typically, as standard convertibles can be changed into stock at any time and therefore benefit from a rise in the price of the underlying stock, brokers tend to offer lower yields on convertibles. CoCos, on the other hand, benefit from higher yields given the risk. To put this into context, in 2020 the CoCo market offered a yield of around 3.62% vs European corporate bonds with an average yield of around 0.24%, according to Credit Suisse.
A success story was seen in March 2021 when Tesla converted bonds into shares. Holders of these bonds, issued between 2013 and 2014, realized gains of more than 800%.
Trading Contingent Convertible Bonds Vs Preferred Stock
Companies use convertible preferred stock to raise capital, acting as debt security. Convertible preferred stocks are shares that include an option for the holder to convert into a fixed number of common shares after a predetermined date. Unlike CoCos, convertible preferred stock is typically converted at the demand of the shareholder although some contingencies may be in place that permit the company or issuer to permit the conversion. The value of the preferred stock is based on the performance of the common stock.
Trading Contingent Convertible Bonds Vs Redeemable Preferred Stock
Redeemable preferred stock is a type of preferred stock that includes a provision allowing the issuer to buy it back at a specific redeemable price and retire it. If a company issues redeemable preferred stock with an 8% dividend rate in one year but then concludes that it can instead issue new shares with a 4% dividend rate the following year, it can simply call or redeem its more expensive shares. Retail investors will have their positions closed but benefit from the re-purchase at the increased redeemable price.
Warrants give investors the right to purchase an underlying security at a predefined price in the future. Contingent convertibles, on the other hand, offer traders the ability to potentially benefit from realized profits if/when their bonds are converted to stocks.
There are various differences between trading contingent convertible bonds and warrants. Firstly, warrants come with an expiry date, and are therefore viewed as a short-term investment. Instead, CoCos are characterised by their longer expiry duration. Another key difference is the pricing structure. The price at which a retail investor will be permitted to purchase the underlying security in the future is detailed in the warrants at the time of issuance. However, in the case of CoCos, the issuer will use the conversion ratio to determine the number of common shares that an investor would gain upon converting the bonds.
Final Word On Trading Contingent Convertible Bonds
It is easy to see why trading contingent convertible bonds is attractive. The hybrid instrument is witnessing an increase in popularity, given the low-interest, high reward and risk. Remember though, profits are not guaranteed. The conversion trigger rate can quickly result in a negative outcome. Trade with caution and do not risk more than you can afford to lose.
What Are Contingent Convertible Bonds?
Contingent convertible bonds, also referred to as CoCos, are debt securities that are converted into equity if a specified event occurs. Bonds are primarily issued by financial institutions to create new equity allowing the issuer to improve its capital structure.
Are Contingent Convertible Bonds The Same As Convertible Bonds?
Trading contingent convertible bonds are similar to trading standard convertible bonds. Standard convertible bonds can be converted into shares at the choice of the bondholder. CoCos, however, will only be converted into shares once a trigger-altering event occurs.
Are Contingent Convertible Bonds Suitable For New Investors?
CoCos are complex instruments. We would not advise trading contingent convertible bonds if you are a new or inexperienced investor.
When Will Contingent Convertible Bonds Convert To Stock?
Conversion trigger methods can be grouped into three main categories; market-based, capital-based and regulator-based. CoCos that have a high trigger (close to the level) are expected to convert quicker vs those with a low trigger.
Is There An Annual Yield Available When Trading Contingent Convertible Bonds?
Yes, for the majority of contingent convertible bonds, investors will be rewarded with ‘coupons’. The frequency of payments will vary by the issuer but they will be paid up until the date of bond maturity, conversion or write-off date.