Contingent Convertible Bonds (CoCo Bonds or CoCos)

Contingent Convertible Bonds (CoCo Bonds) are convertible bonds which are primarily issued by European financial institutions, particularly banks. They are widely issued by European banking institutions to meet Basel III capital adequacy requirements.

They are very similar to normal convertible bonds, which have convertibility feature built into it, except that the conversion feature is linked to different variables. A normal convertible bond is primarily a debt instrument which pays a coupon rate for the entire duration of the bond. At a particular period in time during the life of the bond, the bond holder has an option to convert the bond into a common equity share. The conversion ratio can be pre-determined at the time of issuance of the bond or can be determined based on the occurance or non-occurance of a particular event. For example, the issuer can specify at the time of issue of the bond that each bond can be (at the option of the investor) converted anytime after 5 years into 5 equity shares. Alternatively, the issuer can specify (at the time of issuance of the bond) that the bonds would be eligible for conversion anytime after 5 years and before maturity, if the share price exceeds let's say USD 150. Usually, the option to convert is given to the bond holder. He/she may exercise the option of convertible or decline it. If the option is exercised, the bond will be converted into a common equity share; otherwise, the bond will continue to exist till maturity.

CoCo Bonds are slighly different from normal convertible bonds. The following are the general converion conditions built into the bond.
  1. Bonds can be converted into common equity shares at a particular price, just like normal convertible bonds (For example, each bond will be converted into 3 common equity shares); or

  2. Bonds can be converted into common equity shares at a specified strike price. For example, a 10 year maturity bond can be converted into a common equity share, anytime after the 6th year, at USD 30 per share. So, for example, if a bond holder is holding 10 bonds each with face value of USD 100, the value of his bond holding is USD 1,000. At the conversion rate of USD 30 per share, the bond holder would receive 33 common equity shares and the fraction of 0.33 share amounting to USD 10 would be settled in cash. Obviously, in this case, the bond holder would exercise his right of conversion only if the underlying stock price is more than USD 30 per share. However, CoCo bonds can have a mandatory conversion option if the stock price reaches a particular level, overriding the option of the investor.

  3. Bonds can be mandatorily converted into common equity shares if the total Tier-1 capital of the bank falls below a particular regulatory threshold. For example, if the Tier-1 capital of the bank falls below 5% of its total risk-weighted assets then the terms may specify that all CoCo bonds will be mandatorily converted into common equity shares, with or without the consent of the investor. This can be risky for the bond investors because if the Tier-1 capital ratio drops, the bank's share price may fall and the investor is forced to convert his debt into equity, which may result in capital losses.

  4. The terms can specify that if the financial institution or bank suffers losses, CoCo bonds will absorb such losses. This is unique to CoCo bonds because, in general, most debt do not absorb losses but CoCo bonds can absorb losses. For example, in 2017, when Banco Popular Espanol SA (Spain's sixth-biggest bank) was taken over by its rival Bankco Santander SA to prevent its collapse, about 1.25 billion worth of CoCos were wiped out to absorb the losses.

  5. They may be perpetual in nature - that means, they may be issued without a maturity.

  6. Issuers can switch-off or skip interest payments if the capital ratios fall to dangerously low levels.

  7. Bonds can be mandatorily converted into common equity shares if any one or more of the above conditions are met.

Benefits of Coco Bonds to Issuers

The following are the benefits to the issuer.
  1. CoCo bonds are treated as capital under Additional Tier 1 (AT1) under Basel III norms. They are, therefore, sometimes referred to as "AT1" bonds.
  2. Unlike normal convertible bonds, CoCo bonds are either automatically convertible into common equity or absort losses whenever capital adequacy falls below a regulatory threshold or trigger.
  3. Financial institutions can postpone interest payment or may write down the debt to Zero, if necessary.

Benefits of CoCo Bonds to Investors

The following are the benefits to investors.
  1. CoCo bonds pay higher interest rates than normal convertible bonds due to the additional risk.
  2. If the financial institution is doing good then conversion may be a good thing as it provides an opportunity for capital gains.

Risks of investing in CoCo Bonds

The following are the risks of investing in CoCo bonds.
  1. Investors have little control over convertibility option as they can be automatically converted into shares without their consent.
  2. If a bank triggers the mandatory conversion feature to cover its capital adequancy then it may result in capital loss to the bond investors.
  3. Investors may find it difficult to sell the bonds if the regulators may prohibit such sale.

Investors in CoCo Bonds

The following are the general investors in these bonds.
  1. Mutual Funds
  2. Hedge Funds
  3. Pension Funds
  4. Portfolio Management Schemes (PMS); and
  5. Corporates

Market size as on August 2020

Currently, there are about 200 issues of CoCo Bonds in Europe, which are together worth about 180 billion Euros (or $212 billion). During this ongoing Corona Virus Pandemic, the yields on some of them have reached a high of 15%, largely due to fears that some banks may skip interest payments.

Market size of CoCo bonds over the years

The CoCo bonds can be issued in many currencies. Currently, they are issued in GBP, USD and Euro. The following are some of the main issuers in various currencies.

Sl No Major issuers in EUR currency Major issuers in USD currency Major issuers in GBP currency
1 Banco Santander SA HSBC Holdings Plc Barclays Plc
2 Banco Bilbao Vizcaya Argentaria SA Credit Suisse Group AG Lloyds Banking Group Plc
3 Cooperatieve Rabobank UA Societe Generale SA Santander UK Group Holdings Plc
4 HSBC Holdings Plc Barclays Plc Nationwide Building Society
5 Intesa Sanpaolo SpA UBS Group AG HSBC Holdings Plc
6 UniCredit SpA Standard Chartered Plc Deutsche Bank AG
7 KBC Groep NV Credit Agricole SA Credit Agricole SA
8 CaixaBank SA Banco do Brasil SA/Cayman CYBG Plc
9 UBS AG ING Groep NV Phoenix Group Holdings
10 Barclays Plc Royal Bank of Scotland Group Plc Coventry Building Society

Reasons of issuance of CoCo Bonds

Regulators played an important role in creation of these bonds. The regulators in Europe were unwilling to put tax payers money in line when a bank fails. They, therefore, wanted someone else to step-in and bear the losses; they looked towards bond holders. Since many of these bonds are "perpetual" in nature and had automatic conversion features, they provided excellent loss absorption capabilities. Also, the interest payments can be switched off if the capital ratios fall to dangerously low levels.

Coco Bonds cannot be issued by US banks. They are prohibited by law. US banks depend on preferrential shares and/or traditional convertible bonds. Some countries use a cross between the two.

CoCo Bonds Indexes

CoCo Bond Indexes are currently available for investing. Investors can trade in indexes instead of buying the CoCo bonds themselves. There are only a few CoCo bond Index providers of which IHS Markit is the most popular one. IHS had created the Markit iBoxx Contingent Convertible Indices for trading purposes. It is a family of CoCo indexes, which provide broad representation of the developed and emerging market bank CoCo issuance in GBP, EUR and USD, including both AT1 and T2 capital tier debt. The bonds included in the indices are rated by at least one of the main rating agencies such as Moody's, S&P or Fitch.

The following are some of the indices in the iBoxx family, along with their ISIN Number, Bloomberg ID and RED Id.

Sl No Index ISIN Bloomberg Id RED Id
1 iBoxx EUR CoCo Liquid Developed Market AT1
2 iBoxx EUR Corporates
3 iBoxx EUR Liquid High Yield
4 iBoxx GBP Corporates
5 iBoxx USD CoCo Liquid Developed Market AT1
6 iBoxx USD Liquid High Yield
7 iBoxx USD Liquid High Yield Oil & Gas
8 iBoxx USD Liquid Investment Grade
9 iBoxx USD Liquid Investment Grade 10 + Index
10 iBoxx USD Liquid Leveraged Loans


Updation History
First updated on 23th September 2020.