Contingent Convertible Capital Instruments (CoCos)

Welcome to the fiftieth Pari Passu newsletter. It has been a long way since our first post, and I am excited for the next thousand editions. Thanks for being a reader!

In this edition of Pari Passu, we will learn more about Contingent Convertible Capital Instruments, a topic I admittedly never heard until late 2022.

Contingent Convertible Capital Instruments

If you have been following the Credit Suisse situation, AT1 bonds should be familiar. AT1 bonds are additional tier 1 securities not defined as equity but not purely as bonds. These securities are hybrid or contingent concepts that this paper will touch on. The company wrote off 18bn of these AT1 bonds in the Credit Suisse situation. Specifically, these bonds were contingent convertible capital securities (CoCos). 

How do CoCos work?

Contingent convertible capital instruments are hybrid securities that can absorb the losses of financial institutions. As we will discuss later with Credit Suisse, these instruments can be written off to zero or converted to equity. The primary purpose of these securities is to assist banks in distress. CoCos are structured to absorb losses even to the point of bankruptcy. However, these securities don't always act as a loss-absorber. They have to be 'activated.' CoCos are not a common feature in American banks. Instead, they are often used in Europe as protection for writing bad loans or suffering from a bad investment. CoCos were created, as you can imagine, after the 2007-08 global financial crisis.

Furthermore, beyond CoCos existing in additional tier one bonds, there are additional tier 2 bonds, denoted as AT2. These tier 2 bonds are still subordinated to unsecured creditors like AT1 bonds. However, AT1 bonds are structured to exist indefinitely, just like equity. AT2 bonds have more similar traits to debt, with a minimum maturity period of 5 years. This inherently makes them less risky. To understand this, ask yourself the two methods by which creditors achieve recoveries. They achieve returns from the accretion and return of the bond price at the maturity date and the coupon yields. Since AT1 bonds have no maturity, their return is generated solely from riskier coupon yields. Furthermore, if a company defaults tomorrow, AT2 bonds sit higher in the capital structure than AT1 bonds, making AT1s worse off.

A type of convertible security similar to CoCos is convertible bonds. Convertible bonds are bonds that contain a conversion price. Suppose the conversion price is in the money (i.e., the conversion price is lower than the stock price). In that case, the convertible bonds are assumed to be converted into common equity shares. Furthermore, CoCos involve more risk because it can be written down or converted to equity at any point in time without the specific consent of a bondholder. As a result, the convertible bonds pay higher interest rates to justify these increased risks. The final difference between these two debt products is that convertible bonds will have priority over CoCos in the case of bankruptcy [1]. 

Subscribe to Pari Passu Premium to read the rest.