Contingent Convertible Key Facts for Investors

Core Description

• Contingent Convertibles (CoCos) are high-yield, loss-absorbing bank capital instruments with significant risk features not seen in traditional bonds.
• Triggers, discretionary coupons, and regulatory authority can subject CoCos to abrupt conversion or write-down, as evidenced by high-profile cases such as the 2023 Credit Suisse AT1 write-off.
• Investing in CoCos requires robust due diligence, a diversified approach, and a strong understanding of their unique risk-return dynamics.

Definition and Background

Contingent Convertible bonds, commonly referred to as CoCos or Additional Tier 1 (AT1) instruments, are hybrid securities issued by banks. Their main function is to strengthen a bank’s capital position during periods of financial stress. When specific triggers—predetermined by regulatory or contractual agreements—are breached, these instruments either convert into equity or are written down, absorbing losses. This automatic conversion mechanism allows banks to enhance their equity cushions and continue operating without the need for direct government or taxpayer intervention.

The development of CoCos can be traced back to the aftermath of the 2007-2008 global financial crisis, which revealed inadequacies in traditional bank capital structures as loss-absorbing buffers ahead of insolvency or resolution. Consequently, international regulatory reforms, such as Basel III, introduced the preference for capital forms capable of absorbing losses while the bank remains solvent. CoCos address this need as they can be triggered by financial metrics (such as a decline in the Common Equity Tier 1, or CET1, ratio) or by regulatory discretion at the “point of non-viability” (PONV).

The primary market for these instruments is in Europe, where banks in Switzerland, the UK, and the Eurozone have been particularly active. Over time, the CoCo market has seen the emergence of standardized contracts, rating methodologies, and greater transparency, but continues to feature distinct legal and jurisdictional variations.

Calculation Methods and Applications

Calculation Techniques for CoCos

Valuation of CoCos involves credit, equity, and option-based modeling due to their hybrid characteristics. The main variables affecting CoCo pricing and risk assessment include:

• Coupon and Call Schedule: CoCos are usually perpetual but callable (often after five years). Coupon rates are higher than those of ordinary bonds, but are fully discretionary and non-cumulative.
• Trigger Type and Level: Each CoCo details mechanical (e.g., CET1 ratio falling below 5.125% or 7%) and/or regulatory (PONV) triggers.
• Conversion/Write-Down Terms: The terms specify whether, upon trigger, the security converts to shares (at a fixed or floating price) or undergoes a full or partial principal write-down.
• Risk Metrics: These include the distance to trigger (CET1 – trigger ratio), probability of the trigger event (often estimated via the volatility of assets or equity), and sensitivity to issuer-specific and market-wide risks.

Example Calculation: Dilution and Ownership

As a hypothetical scenario, if a CoCo has a par value of USD 1,000 and is triggered at a conversion price of USD 1.10 per share, the conversion ratio would be roughly 909 shares per bond. With 1,000,000 bonds outstanding and 10,000,000 shares pre-trigger, after conversion, CoCo holders would own a significant portion of the institution, illustrating both potential recovery for CoCo holders and dilution risk for existing shareholders.

Application Scenarios and Quantitative Tools

CoCos are important to banks’ capital planning, particularly for meeting regulatory benchmarks such as TLAC (Total Loss Absorbing Capacity) and MREL (Minimum Requirement for own funds and Eligible Liabilities). For investors, scenario analysis proves valuable:

• Distance-to-Trigger Estimation: Stochastic modeling is used to reflect capital ratio drift (average and volatility), often mapped to annual probability multipliers.
• Price/Yield Modeling: Approaches incorporate option-adjusted spread (OAS), expected coupon barring trigger events, and probability-weighted principal loss. Models frequently reference swap rates, credit spreads, and implied volatility indices.

Table: Key Definitions in CoCo Calculation

Comparison, Advantages, and Common Misconceptions

Comparison Against Other Instruments

• Traditional Convertibles: Traditional convertibles typically offer investors the option, not obligation, to convert to equity at a time of their choosing, often for capital growth. CoCos, by contrast, convert mandatorily upon adverse events, with limited upside for bondholders.
• Straight (Senior) Bonds: Senior bonds provide fixed coupons and principal, absent default, without a loss-absorption mechanism. CoCos are subordinated, designed to absorb losses while the bank is solvent, resulting in relatively higher yields but significant downside risk.
• Tier 2 Subordinated Debt: Tier 2 instruments generally absorb losses only upon liquidation and are less subordinated than AT1/CoCos. They are less likely to be written down prior to insolvency.
• Preferred Shares: Preferred equity is perpetual and often pays non-cumulative dividends, but typically lacks regulatory triggers for conversion or write-down.

Key Advantages

For Issuers:

• Go-concern loss absorption supports regulatory capital ratios and buffers.
• Ability to suspend coupons preserves cash during stress events.
• Tax-deductible coupon payments and flexibility in capital optimization.

For Investors:

• High coupons provide compensation for greater risks.
• Potential price recovery if issuer risk declines or securities are called.
• Diversification across banks and capital structures.

For Regulators and the System:

• Private sector absorbs losses before taxpayer involvement.
• Promotes market discipline and supports early recapitalization.

Core Disadvantages

• Elevated risk of principal loss from triggers, especially with permanent write-downs.
• Extreme subordination increases the severity of potential losses.
• Coupons can be suspended indefinitely and are non-cumulative.
• Significant pricing volatility based on issuer health and regulatory actions.

Common Misconceptions

• CoCos always convert to equity: Many are in fact subject to principal write-down with no equity upside.
• Coupons are guaranteed: They may be canceled with no obligation for future payment.
• Triggers are market price based: Most are based on regulatory or accounting measures, not market prices.
• AT1 risk is similar to senior debt: CoCos carry considerably higher risk and may absorb losses before equity in some jurisdictions.

Example – Recent Market Event

In 2023, the write-down of CHF 16,000,000,000 in Credit Suisse CoCos surprised holders as equity investors retained value, overruling the presumed seniority of AT1 capital over common shares in certain jurisdictions. This event emphasized the importance of precise contract language, regulatory intent, and local legal frameworks in outcome determination.

Practical Guide

Setting Investment Objectives

Begin by clarifying your investment goals—whether seeking income or total return—and determine your time horizon and risk tolerance. Recognize that CoCos provide asymmetrical returns: attractive coupons may be offset by sudden, significant losses resulting from trigger events or regulatory actions.

Understanding Triggers and Loss Absorption

Familiarize yourself with mechanical and regulatory triggers, such as CET1 thresholds or PONV. For risk mitigation, consider CoCos with higher, more transparent triggers and conversion (rather than write-down) features, as these may allow some recovery via equity issuance.

Evaluating Issuer Fundamentals

Conduct due diligence on issuers’ solvency, profitability, asset quality, and capital buffers. Monitor CET1 ratios, regulatory buffer headroom, and MDA limits influencing coupon continuity.

Analyzing Structure and Pricing

Analyze each CoCo’s terms for yield composition, call schedule, reset mechanics, and extension risk. Assess the likelihood of being called versus remaining outstanding, since price volatility and a lower yield-to-maturity may result when extension occurs in stressed markets.

Managing Position Size and Diversification

Limit exposure to individual issuers and avoid large concentrations in the same jurisdictions or banking groups. Position size should reflect possible stressed-loss scenarios rather than just nominal size.

Liquidity Management and Trade Execution

Prefer highly liquid lines, use limit orders to avoid adverse price swings, and note possible illiquidity driven by auction processes or headlines. Use regulated brokers with reliable systems for corporate actions and conversions.

Ongoing Monitoring

Monitor leading indicators: CET1 ratio movements, widening credit spreads, increases in CDS prices, or regulatory investigations. Reduce risk as coupon restriction events, rights issues, or depleted capital buffers approach.

Exit Strategies

Prepare for stressed exit scenarios—such as recession, sovereign events, or legal challenges—and define clear exit rules at coupon or call dates, or when approaching trigger thresholds.

Case Study: Credit Suisse 2023 AT1 Write-Down

Background:
In March 2023, Swiss regulators enacted a complete write-down of CHF 16,000,000,000 in Credit Suisse AT1 CoCos when the firm reached the “point of non-viability,” facilitating UBS’s acquisition. Despite the common hierarchy where AT1 should rank above equity, the instrument's documentation and Swiss law permitted the write-off even as equity holders retained residual value.

Key Takeaways:

• Investors underestimated regulatory discretion and the impact of local regulations.
• Prospectus wording and jurisdictional law were decisive factors.
• Liquidity quickly disappeared, highlighting execution risk under stress.

Implications:
Subsequent investors increased their focus on examining prospectus details, understanding trigger mechanics, and closely monitoring jurisdictional differences in regulation.

Resources for Learning and Improvement

• Academic Journals and Working Papers:
  Review foundational research on contingent capital from the Bank for International Settlements (BIS), SSRN, and NBER. Notable authors include Calomiris & Herring, Bulow & Klemperer.

• Books:
  “Options, Futures, and Other Derivatives” by John Hull covers convertible structures. “Fixed Income Markets” by Sundaresan discusses contingent claims modeling in fixed income.

• Regulatory Documentation:
  Refer to EU, UK, and Basel III guidance on Additional Tier 1 capital; EBA and PRA documentation on buffers, coupon cancellation, and PONV triggers.

• Industry Research and Data:
  S&P, Moody’s, and Fitch hybrid criteria reports explain coupon deferral and risk-based tiering; Bloomberg and Refinitiv provide pricing, trigger maps, and coupon calendars.

• Conferences, Webinars, and Lectures:
  Engage in events by Risk.net, CEPR, ICMA, as well as university lectures on legal frameworks for bail-in capital.

• Professional Certifications:
  CFA, CAIA, and FRM programs offer relevant modules on hybrid capital, risk modeling, and financial regulation.

• Case Studies:
  Studying official reviews and reports on Banco Popular (2017), Credit Suisse (2023), and Yes Bank (2020) enhances understanding of practical risk and legal outcomes.

FAQs

What are Contingent Convertibles (CoCos)?

Contingent Convertibles, or CoCos, are hybrid securities issued by banks that absorb losses either by converting into equity or by being written down when specific regulatory or contractual triggers are breached. They are a significant component of bank capital and risk management.

How do triggers work for CoCos?

Triggers are predefined events, often tied to regulatory capital ratios (like CET1 falling below a set threshold) or regulatory assessment (point of non-viability, PONV). When a trigger is activated, the CoCo is either converted to equity or written down as specified.

What happens when a CoCo is triggered?

Once triggered, CoCos either convert into a set number of shares (diluting existing shareholders) or are written down (permanently or temporarily). Full details are provided in the prospectus.

How do CoCos differ from traditional convertible bonds?

Traditional convertibles give investors the option to convert for upside, while CoCos convert mandatorily only under stress events to support the solvency of the issuing bank and are perpetual with discretionary coupons.

Can CoCo coupons be canceled?

Yes, CoCo (AT1) coupons are fully discretionary and non-cumulative. Both issuers and regulators can cancel coupons without default, especially in periods of stress or if capital ratios fall below specified limits.

What risks are unique to CoCos?

Key risks include trigger risk, principal loss from conversion or write-down, coupon suspension, subordination in the capital structure, extension risk, and legal or contractual uncertainty.

Who typically invests in CoCos?

Primary investors are institutional, including asset managers, insurers, hedge funds, and private banks, given the complexity and volatility of these instruments.

How liquid is the CoCo market?

Liquidity varies but tends to be greater for large, frequently traded issues. However, liquidity can dry up quickly under stress, resulting in rapid price declines.

Why were Credit Suisse’s AT1 CoCos written down in 2023?

Swiss regulators determined Credit Suisse had reached the point of non-viability, and local laws and bond contracts permitted total loss absorption from AT1s, even as equity maintained value, contrary to the usual capital hierarchy.

How are CoCos valued by investors?

Valuation uses a blend of credit and equity modeling, incorporating probability-weighted expected cash flows, distance-to-trigger analytics, and call/extension scenario analysis. Yield and price reflect both coupon income and the probability of sudden principal loss.

Conclusion

Contingent Convertibles are an important element in modern bank capital structures, proactively absorbing losses and supporting regulatory solvency. While they offer substantial coupon yields, CoCos present risks beyond those associated with conventional bonds, including sudden conversion or write-down, coupon suspension, and complex triggers shaped by both numerical and regulatory factors.

Thorough analysis of issuer fundamentals, understanding of jurisdiction-specific legal frameworks, and close attention to prospectus details are crucial for managing CoCo risk. Events such as the Credit Suisse 2023 AT1 write-down underscore the importance of comprehensive due diligence, portfolio diversification, and scenario planning.

CoCos may have a role within institutional portfolios seeking yield and diversification, but due to their complexity, ongoing learning and careful risk management are necessary. As regulatory and market conventions continue to evolve, staying informed and applying a disciplined approach is essential for considering this unique asset class.