Contingent Convertible Bonds

What Are Contingent Convertible Bonds (CoCo)?

Contingent Convertible Bonds (CoCos) are a type of hybrid financial instrument that can be converted into stocks or equity of the issuing company if the strike price is breached. Banks and financial institutions issue these bonds, and they combine elements of both debt and equity securities. They aim to strengthen a bank's capital position during times of financial stress.

These bonds have a unique feature where they automatically convert into equity if specific predefined triggers are breached, like the entity's capital ratio falling below a certain threshold. This conversion is contingent on the institution facing financial distress. The bonds offer higher yields as they carry high risk.

• Contingent Convertible Bonds are financial instruments that may convert into the issuing company's equity or stocks if the pre-established strike price is breached. Banks and financial institutions primarily issue these bonds.
• The bond's conversion feature is contingent on the institution facing economic turmoil. It strengthens the issuer's capital base and enhances its economic stability without relying on external funding sources.
• These bonds assist the institutions in meeting regulatory capital requirements. However, its value may be highly volatile due to market uncertainty.

Contingent Convertible Bonds Explained

Contingent Convertible Bonds (CoCos), are unique financial instruments that possess the features of both debt and equity securities. These bonds are primarily issued by banks and financial institutions and serve a crucial role in boosting their capital positions, especially during economic distress.

The "contingent" aspect of CoCos means that their conversion is contingent on predefined triggers being breached. These triggers are generally related to the issuing institution's financial health, like its capital adequacy. Additional triggers include the entity's capital ratio falling below a predetermined threshold or regulatory requirements not being met.

When one of these triggers is breached, the CoCos can transform. They automatically convert into common equity shares of the issuing organization. This conversion mechanism is designed to act as a built-in shock absorber for the institution's capital structure during times of financial turmoil.

Features

Some features of CoCosare:

• Its primary feature is its contingency. These bonds automatically convert into common equity shares of the issuing institution when specific predefined triggers are breached. These triggers are linked to the issuer's capital adequacy or regulatory capital requirements.
• CoCos serve as a capital buffer for the issuing institution. When triggered, their conversion into equity strengthens the issuer's capital base. This feature helps the institution meet regulatory capital requirements like those set by Basel III. They help enhance an entity's financial stability during times of economic stress without resorting to external funding sources.
• They often offer higher yields compared to traditional bonds due to their riskier nature. The higher yield reflects the increased risk that investors take by holding CoCos, as their value can be volatile and dependent on the issuer's financial health.
• The specific triggers and terms for conversion are outlined in the bond's prospectus. These terms may vary widely among different CoCo issuances.
• The conversion of CoCos into equity can dilute the ownership stakes of existing shareholders. This dilution risk may impact share prices and the distribution of ownership within the issuing institution.

Examples

Let us go through the following examples to understand these bonds:

Example #1

Suppose Jake was considering a CoCo issued by Credit First Bank. It had a face value of $1,000 and offered a 5% annual interest rate. The contingency was that if the bank's capital ratio fell below a certain level, the CoCo would convert into shares of the bank's stock.

After a few months, the Credit First Bank's capital ratio dropped below the trigger level due to financial difficulties. At this point, Jake's CoCo converted into shares of the bank. The bank's stock price was $20 per share at the time of conversion. Thus, Jake received 50 shares since he invested $1,000 in the bonds.

Example #2

According to The Guardian, on May 20, 2023, Invesco's AT1 Capital Bond exchange-traded fund (ETF), which follows the value of AT1 debt issued by banks, is down 15%. According to a media report, derivatives that monitor the value of riskier bank debt, like those that were eliminated in the Credit Suisse acquisition, are decreasing dramatically. Investors were shocked that AT1 bonds issued by Credit Suisse were being written off despite the fact that the bank's equity had not been wholly destroyed.

AT1 bonds are often intended to rank above equity in the debt hierarchy. According to Neil Wilson, the chief markets analyst at Markets.com, the 'blatant' disruption of the debt hierarchy will have consequences.

CoCos And The Credit Suisse Failure

The failure of Credit Suisse in 2021 underlined the role and challenges of CoCos in the banking sector. Credit Suisse had issued these bonds as a means of boosting its capital position. They had a contingent conversion feature, implying they would automatically convert into equity if the bank's capital ratio fell below a certain threshold. However, when Credit Suisse encountered financial difficulties, the CoCos didn't function as expected. Their conversion would have led to significant dilution for existing shareholders, potentially destabilizing the bank further. This raised questions about the bonds' effectiveness in preserving financial stability during crises.

The Credit Suisse contingent convertible bonds case also highlighted the complexity of CoCos. Moreover, it underscored the importance of carefully assessing the terms and triggers associated with these financial instruments, as the specific terms of the bonds may vary widely. In response to these challenges, regulators and financial authorities have continued to refine the rules related to CoCos. They aimed to strike a balance between reinforcing banks' capital positions and ensuring that these bonds don't aggravate financial instability during times of stress.

Benefits

The benefits of CoCos include:

• They can assist banks in complying with regulatory capital requirements, like those outlined in Basel III. By issuing CoCos, banks can improve their capital ratios without the need for external fundraising. It helps reduce the risk of non-compliance and associated penalties.
• For investors, CoCos offers an opportunity to diversify their portfolios. These instruments often provide higher yields compared to traditional bonds. Thus, it makes them attractive to income-seeking investors.
• These bonds usually offer higher coupon rates or yields owing to their increased risk profile. It can be appealing to investors who seek higher returns on their investments.
• The bonds can help enhance coordination in the financial industry. The conversion may lead to losses for bondholders and dilution for existing shareholders. So, it aligns the interests of investors and the bank's management with maintaining financial stability.

Risks

The contingent convertible bonds risks are:

• CoCos are designed to convert into equity or stock when specific predetermined triggers are breached. This conversion or write-down can lead to losses for bondholders.
• They are known for their complexity, primarily due to the contingent conversion mechanism and varying trigger conditions. Understanding the specific terms and risks associated with each CoCo issuance may be challenging, making them less suitable for novice investors.
• The CoCos' value is closely associated with the issuing institution's financial status. If the issuer faces financial difficulties, the likelihood of CoCo conversion increases, leading to significant losses for investors.
• Its value can be highly volatile, especially during times of market uncertainty or when there are concerns about the issuer's financial stability. This volatility can make it difficult for investors to predict the value of their CoCo investments.

Contingent Convertible Bonds vs Convertible Bonds

The differences between the two are as follows:

Contingent Convertible Bonds

• CoCos have predefined triggers, like the issuer's capital ratio falling below a specific threshold or regulatory requirements not being met.
• They are considered riskier than traditional convertible bonds because the conversion or write-down is tied to the issuer's financial distress. This feature makes their value more volatile and dependent on the issuer's stability.
• CoCos usually pay higher coupon rates compared to traditional bonds to compensate investors for the added risk they bear.

Convertible Bonds

• Convertible bonds provide bondholders with the option to convert their bonds into a predetermined number of common shares of the issuer's stock at a specified conversion price. This conversion is not contingent on specific trigger events. It is based on the bondholder's choice.
• These bonds are generally less risky because the conversion feature is not tied to the issuer's financial distress. Bondholders have the flexibility to convert if the issuer's stock price rises, but they can also choose not to convert and receive the bond's face value at maturity.
• They are attractive to investors seeking income and equity appreciation. Issuers of convertible bonds have greater flexibility in terms of capital management.

Frequently Asked Questions (FAQs)

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