What it means
A CoCo starts life looking like an ordinary bond, paying a stated coupon on a stated principal. What makes it different is a trigger written into the terms, usually expressed as a common equity tier 1 ratio, which is the bank's core capital divided by its risk weighted assets.
If that ratio falls below the trigger, the bond converts automatically. Depending on the terms the holder either receives shares at a pre-agreed price or sees the principal permanently written down, and in the harsher versions the money simply disappears while shareholders keep something.
The point of the design is to recapitalise a bank without public money. Converting debt into equity, or cancelling it outright, rebuilds the capital ratio at the exact moment the bank needs it most, which is when raising fresh money in the open market would be impossible.
Coupons are high for good reason. Investors demand compensation for a security that can be wiped out before the shares are, for coupons the regulator can cancel without that counting as a default, and for a perpetual structure with no guaranteed repayment date.
The instruments have behaved unpredictably in practice. Their prices can fall much faster than the underlying shares once a bank looks weak, because holders face a cliff rather than a slope, and that price fall can itself accelerate the loss of confidence the instrument was meant to contain.
For anyone outside banking the relevance is mainly as a lesson about yield. A bond paying several percentage points more than comparable debt is being paid for a risk somebody has priced at exactly that much, and here the risk is total loss while the issuer remains a going concern.
In practice
Real-world examples.
Example
A pension fund seeking income buys a bank CoCo yielding 8% when comparable senior bank debt yields 4%. The extra 4 percentage points is the price of accepting that the holding can be written to zero without the bank ever entering insolvency.
Example
A bank's regulator questions its capital planning and the bank suspends the coupon on its CoCos for a quarter. No default occurs, because the terms make coupons discretionary, but the share price falls sharply as investors read the suspension as a warning signal.
Example
A credit analyst comparing two banks notices that one has a trigger set at 7% and the other at 5.125%. The higher trigger makes conversion far more likely, so the analyst treats the two instruments as materially different risks despite their similar yields.
Formula
Calculation
CET1 ratio = common equity tier 1 capital / risk weighted assets
Conversion or write-down occurs when the CET1 ratio falls below the trigger stated in the bond terms.
A bank has risk weighted assets of $50,000,000,000 and CET1 capital of $3,500,000,000, giving a CET1 ratio of $3,500,000,000 / $50,000,000,000 = 7.0%. It has $1,000,000,000 of CoCos outstanding paying a 7.5% coupon, or $75,000,000 a year, with a trigger set at 5.125%.
A bad year produces $1,200,000,000 of losses. CET1 capital falls to $3,500,000,000 - $1,200,000,000 = $2,300,000,000 and the ratio drops to $2,300,000,000 / $50,000,000,000 = 4.6%, below the 5.125% trigger.
The CoCos are written down in full. The $1,000,000,000 of debt disappears from the balance sheet and adds to core capital, lifting CET1 to $2,300,000,000 + $1,000,000,000 = $3,300,000,000 and the ratio back to $3,300,000,000 / $50,000,000,000 = 6.6%. The bondholders lose their entire $1,000,000,000 and the $75,000,000 annual coupon, while ordinary shareholders, whose shares are worth far less than before but who are not diluted at all, since no new shares are issued in a write-down, still hold their entire stake.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Carradale Bank, an invented mid-sized lender, issued $800,000,000 of contingent convertibles at a 6.5% coupon, costing it $52,000,000 a year, with a conversion trigger at a 5.125% CET1 ratio and a conversion price of $4.00 a share.
Carradale ran with risk weighted assets of $30,000,000,000 and CET1 capital of $2,100,000,000, a ratio of 7.0%. A downturn in its commercial property book produced $700,000,000 of write-downs, cutting capital to $1,400,000,000 and the ratio to $1,400,000,000 / $30,000,000,000 = 4.67%, comfortably through the trigger.
Because these fictional CoCos converted rather than being written off, the $800,000,000 became $800,000,000 / $4.00 = 200,000,000 new shares at a moment when the market price was $1.10, so the bondholders received stock worth about 200,000,000 x $1.10 = $220,000,000 against $800,000,000 of principal. Capital rose to $1,400,000,000 + $800,000,000 = $2,200,000,000 and the ratio to 7.33%, so the bank stayed open. The illustrative point stands: the instrument did its job for the bank and cost its holders roughly 73% of their money.
Watch out
Common mistakes.
- Treating a CoCo as an ordinary bond because it pays a coupon, when the principal can be cancelled entirely while the issuer carries on trading normally.
- Assuming bondholders always rank ahead of shareholders, since a write-down CoCo can be extinguished while ordinary shares survive.
- Comparing CoCo yields with senior bond yields as though the difference were free extra income, rather than payment for a specific and severe risk.
Questions
People also ask.
What does the trigger level actually refer to?
The bank's common equity tier 1 ratio, its core capital divided by risk weighted assets, and a higher trigger means conversion happens earlier and the bond is riskier.
Can a bank stop paying the coupon without defaulting?
Yes, coupons on these instruments are discretionary and can be cancelled by the bank or its regulator without that counting as an event of default.
Who typically buys them?
Mainly institutional investors such as hedge funds, insurers and specialist credit funds, and in many markets they cannot be sold to retail investors at all.
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