# Contingent Convertibles (CoCos): Definition and Use in Europe

![Contingent Convertibles (CoCos): Debt securities that convert into common stock if a pre-defined trigger event occurs.](https://www.investopedia.com/thmb/dBdTR9n5O_Y3y5_P4qnZ8M3fXiI=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Contingentconvertible_final-0ecd03cc4eb949a39a3da929bb5b9659.png)

*— Investopedia / Michela Buttignol*

## What Are Contingent Convertibles (CoCos)?

Contingent convertibles (CoCos) are [debt instruments](https://www.investopedia.com/terms/d/debtinstrument.asp) primarily issued by European financial institutions. These securities work in a fashion similar to traditional convertible bonds. They have a specific [strike price](https://www.investopedia.com/terms/s/strikeprice.asp) that, once breached, allows the conversion of the bond into equity or stock.

CoCos, also known as AT1 bonds, are high-yield, high-risk products. A CoCo is also referred to as an enhanced capital note (ECN). The importance of this hybrid debt security is that it carries specialized options that help the issuing [financial institution](https://www.investopedia.com/terms/f/financialinstitution.asp) absorb a [capital loss](https://www.investopedia.com/terms/c/capitalloss.asp).

CoCos can help to shore up a bank’s [balance sheets](https://www.investopedia.com/terms/b/balancesheet.asp) by allowing it to convert its debt to stock if specific, unfavorable capital conditions arise. They were created after the 2007–2008 global financial crisis to help undercapitalized banks and to reduce the potential for taxpayer-funded bailouts.  

### Key Takeaways

*   CoCos have a strike price at which the bond can be converted into stock.
*   They're are used by the banking industry to absorb losses automatically and to satisfy regulatory capital requirements.
*   A bank that's struggling financially does not have to repay the bond, make interest payments, or convert the bond to stock.
*   CoCo investors receive interest payments that are typically much higher than those from traditional bonds.

## Understanding Contingent Convertibles (CoCos)

### Purpose

Cocos are designed to automatically cover bank losses and aid them in satisfying additional Tier 1 (AT1) and [Tier 2 (T2)](https://www.investopedia.com/terms/t/tier2capital.asp) regulatory capital requirements imposed by Basel III.

### CoCos vs. Convertible Bonds

There is a significant difference between bank-issued contingent convertibles bonds and standard convertible bonds. [Convertible bonds](https://www.investopedia.com/terms/c/convertiblebond.asp) have bond-like characteristics. They pay a regular rate of interest and have seniority in the case of the underlying business [defaulting](https://www.investopedia.com/terms/d/default2.asp).

These debt securities also allow the bondholder to convert the debt security into the issuer's common stock shares at a specified strike price. This gives investors the potential for share price appreciation. The strike price is a specific stock price that needs to be reached for the conversion to occur.

Investors can benefit from convertible bonds since the bonds can be converted to stock when the company’s stock price is [appreciating](https://www.investopedia.com/terms/a/appreciation.asp). The convertible feature allows [investors](https://www.investopedia.com/terms/i/investor.asp) to enjoy both the benefits of bonds with their fixed interest rate and the potential for capital appreciation from a rising stock price.

### CoCos Have Different Features

Contingent convertibles expand on the concept of convertible bonds by modifying the conversion terms. As with the convertible bond, investors receive periodic, fixed-interest payments during the life of the bond. But CoCos automatically create a loss for investors if the issuer's capital drops under a specific level. Reaching these points of, normally, 7% or 5.125% of total risk-weighted assets can cause three potential results for investors:

*   A CoCo being converted to common shares
*   A temporary write-down of the CoCo's value
*   A permanent write-down of the CoCo's value

Broadly, the trigger can take several forms, including the price of the underlying shares, the bank’s need to meet regulatory capital requirements, or the demand of a managerial or supervisory authority.

> **Tip**
>
> The use of CoCos has not yet been introduced in the U.S. banking industry.

## Background of CoCos

Contingent convertibles became popular as an aid to financial institutions in meeting Basel III capital requirements. [Basel III](https://www.investopedia.com/terms/b/basell-iii.asp) is a regulatory accord outlining a set of minimum standards for the banking industry. Its goal was to improve the supervision, risk management, and the regulatory framework for the critical financial sector.

### Basel III Framework

As part of the standards, a bank must maintain enough [capital](https://www.investopedia.com/terms/c/capital.asp) to be able to withstand a financial crisis and absorb unexpected losses from loans and investments. The Basel III framework tightened banks' capital requirements by limiting the kind of capital that they could include in their various capital tiers and structures.

One type of bank capital is [Tier 1 capital](https://www.investopedia.com/terms/t/tier1capital.asp)—the highest-rated capital available to offset bad loans on the institution’s balance sheet. Tier 1 capital includes [retained earnings](https://www.investopedia.com/terms/r/retainedearnings.asp)—an accumulated account of profits—as well as common [stock](https://www.investopedia.com/terms/s/stock.asp) shares. Banks issue shares to investors to raise funding for their operations and to offset bad debt losses.

CoCos act as additional Tier 1 capital (AT1), helping European banks to meet the Basel III requirements. They allow a bank to absorb the loss of underwriting bad loans or other financial industry stress.

## How Banks Use Contingent Convertibles

Banks use contingent convertibles differently from the way corporations use convertible bonds. Banks have their own set of parameters that warrant the bond’s conversion to stock. The [triggering event](https://www.investopedia.com/terms/t/triggeringevent.asp) for CoCos can be the bank’s value of Tier 1 capital, the judgment of supervisory authority, or the value of the bank’s underlying stock shares.

Banks absorb financial loss through CoCo bonds. Instead of converting bonds to common shares based solely on stock price appreciation, investors in CoCos agree to take equity in exchange for the regular income from the debt when the bank’s capital ratio falls below regulatory standards.

Importantly, the stock price might be lower than desired when a conversion is triggered. If the bank is having financial difficulty and needs capital, this is reflected in the value of its shares. As a result, CoCos can convert to equity while the stock’s price is declining. This puts investors at risk for losses.

### Benefits for Banks

1\. Contingent convertible bonds are an ideal product for undercapitalized banks in markets around the globe since they come with an [embedded option](https://www.investopedia.com/terms/e/embeddedoption.asp) that allows banks to meet capital requirements and limit capital distributions at the same time.

2\. The issuing bank benefits from the CoCo by raising capital from the bond issue. However, if the bank has underwritten many bad loans, it may fall below its Basel Tier 1 capital requirements. In this case, the CoCo carries a stipulation that the bank doesn’t have to pay periodic interest payments, and it may even write down the full debt to satisfy Tier 1 requirements.

3\. When the bank converts the CoCo to shares, it may remove the value of the debt from the [liability](https://www.investopedia.com/terms/l/liability.asp) side of its balance sheet. This bookkeeping change allows the bank to underwrite additional loans.

4\. The security has no end date at which time the [principal](https://www.investopedia.com/terms/p/principal.asp) must return to investors. If the bank experiences financial hardship, it can postpone the payment of [interest](https://www.investopedia.com/terms/i/interest.asp), force a conversion to [equity](https://www.investopedia.com/terms/e/equity.asp), or, in dire situations, [write the debt down](https://www.investopedia.com/terms/w/writedown.asp) to zero.

> **Fast Fact**
>
> U.S. banks issue preferred stocks instead of CoCos to meet AT1 capital requirements.

## Benefits and Risks of CoCos for Investors

### Benefits

*   Due to their high yield in a world of safer, lower-yielding products, the popularity of contingent convertibles has grown. Many investors buy CoCos in the hope that the bank will one day redeem the [debt](https://www.investopedia.com/terms/d/debt.asp) by buying it back, and, until it does, they will pocket the high returns and accept the higher-than-average risk.
*   Investors receive common shares at a conversion rate set by the bank. The financial institution may define the share conversion price as the same value as when the debt was issued, the market price at conversion, or any other desired price level.

### Risks

*   One downside of CoCo's share conversion is that the share price will be [diluted](https://www.investopedia.com/terms/d/dilution.asp), further reducing the [earnings per share](https://www.investopedia.com/terms/e/eps.asp) ratio.
*   There’s no guarantee that the CoCo will ever be converted to equity or fully redeemed, meaning the investor could be holding the CoCo for years.
*   [Regulators](https://www.investopedia.com/articles/economics/09/financial-regulatory-body.asp) that allow banks to issue CoCos want their banks to be well-capitalized and, as a result, may make selling or unwinding a CoCo position quite difficult for investors.

Pros

*   European banks can raise Tier 1 capital by issuing CoCo bonds.
    
*   If necessary, the bank can postpone interest payment or may write down the debt to zero.
    
*   Investors receive periodic high-yield interest payments.
    
*   If a CoCo conversion is triggered by a higher stock price, investors receive share appreciation.
    

Cons

*   Investors bear the risks and have little control if the bonds are converted to stock.
    
*   CoCos converted to stock can result in investors receiving shares as the stock price is declining.
    
*   Investors may have difficulty selling their position in CoCos if regulators do not allow the sale.
    
*   Banks that issue CoCos have to pay a higher interest rate than that for traditional bonds.
    

## Examples of a Contingent Convertible

Let’s say Deutsche Bank issued contingent convertibles with a trigger set to core Tier 1 capital instead of a strike price. If Tier 1 capital falls below 5%, the convertibles automatically convert to equity, and the bank improves its capital ratios by removing the bond debt from its balance sheet.

If an investor owns a CoCo with a $1,000 face value that pays 8% per year in interest, then the bondholder receives $80 per year. The stock trades at $100 per share when the bank reports widespread loan losses. The bank’s Tier 1 capital falls below the 5% level, which triggers the CoCos to be converted to stock.

The conversion ratio allows the investor to receive 25 shares of the bank’s stock for the $1,000 investment in the CoCo. However, the stock has steadily declined from $100 to $40 over the past several weeks. The 25 shares are worth $1,000 at $40 per share. The investor decides to hold the stock, and the next day, the price declines to $30 per share. The 25 shares are now worth $750, and the investor has lost 25%.

It’s important that investors who hold CoCo bonds weigh the risk that they'll need to act quickly if the bond is converted. Otherwise, they may experience significant losses. As stated earlier, when a CoCo trigger occurs, it may not be an ideal time to purchase the stock.

### CoCos and the Credit Suisse Failure

In 2023, Credit Suisse Group AG’s contingent convertible securities suffered a historic $17 billion loss after [UBS Group AG agreed to buy the bank](https://www.investopedia.com/usb-and-credit-suisse-forced-to-merge-7367988). The Swiss government brokered the deal to contain a spreading crisis of confidence in global financial markets.

The deal triggered a total [write-down](https://www.investopedia.com/terms/w/writedown.asp) of CoCos, which provoked an angry reaction from some bondholders. Credit Suisse had 13 CoCo issues outstanding worth a combined 16 billion Swiss francs.

However, CoCos were designed for crisis points like this and their risks were known.

CoCo bonds of other European lenders also plunged, with Deutsche Bank’s £650 million ($792 million) 7.125% note suffering its biggest-ever one-day decline.

CoCos are a popular way for European banks to raise capital while providing additional loss-absorbing capacity in times of stress. However, Credit Suisse’s experience raised concerns about the future of the CoCo market and AT1 bonds.

While European regulators reiterated that equities should absorb losses before bondholders, the decision to write down the bank’s riskiest debt sparked a furious response from some creditors. It should be noted that most other banks in Europe and the United Kingdom have more protections for their AT1 bonds. Credit Suisse and UBS had language in the terms of their deal that allowed for a permanent write-down.

## How Do CoCos Differ From Convertible Bonds?

Contingent convertibles (CoCos) and convertible bonds both have a price point that triggers the conversion of the bond into equity or stock. However, CoCos have several triggers while traditional convertible bonds have only one.

CoCos pay higher interest rates than convertible bonds due to their risks. They have special options that help banks absorb a capital loss.

Moreover, convertible bondholders have priority should the underlying business default. CoCos are secondary debts issued by banks. CoCos are used mainly by banks to improve their financial position, while corporations use convertible bonds to raise capital.

## Are Contingent Convertibles Regulated?

Yes, CoCos are regulated in the European Union under the Basel III regulatory framework. The framework sets minimum standards for the banking industry to improve supervision, risk management, and capital requirements.

## What Happens to Contingent Convertibles During a Financial Crisis?

During a period of financial stress or uncertainty for banks, the value of CoCos can significantly decrease, as they are high-risk instruments. If a bank is struggling and needs additional capital, the value of its shares may decrease, putting CoCo investors at risk for losses. If a bank fails to meet its capital requirements, it may postpone the payment of interest or convert the bond into equity at a lower price to meet the regulatory standards. In dire situations, the bank may write down the value of CoCos to zero.

## The Bottom Line

Contingent convertibles, or CoCos, are a type of debt instrument issued by European financial institutions. They are similar to traditional convertible bonds in that they can be converted into common stock at a particular strike price.

CoCos are used in the banking industry to shore up banks’ Tier 1 balance sheets, allowing them to absorb a capital loss. Because of this, CoCos are high-yield, higher-risk products, and investors need to weigh the benefits and risks of investing in CoCos carefully.

> **Article Sources**
>
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