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What are 'Contingent Convertibles - CoCos'

Contingent convertibles (CoCos) are similar to traditional convertible bonds in that there is a strike price, which is the cost of the stock when the bond converts into stock. What differs is that there is another threshold in addition to the strike price, which triggers the conversion when certain capital conditions are met. Issuing contingent bonds is more advantageous to companies than issuing regular convertibles.

BREAKING DOWN 'Contingent Convertibles - CoCos'

Contingent convertibles, also known as CoCos, became popular in 2014 to help banks meet Basel III capital requirements. The Basel III standards compare a bank’s assets with its capital to determine if the bank could stand the test of a crisis. Capital is required by banks to absorb unexpected losses that arise during the normal course of the bank’s operations. The Basel III framework tightens the capital requirements by limiting the type of capital that a bank may include in its different capital tiers and structures.

One type of capital in a bank's capital structure is Tier 1 capital, calculated as common equity tier 1 (CET1) capital plus additional Tier 1 capital (AT1). An example of AT1 capital is a contingent convertible which  can be converted into equity when a trigger event occurs. An event that causes a security to be converted to equity occurs when CET1 capital falls below a certain threshold.

Contingent convertible bonds are the perfect product for undercapitalized banks in markets across the globe, including the United Kingdom, China and Switzerland, since they come with an embedded option that allows banks to meet capital requirements and limit capital distributions at the same time. The popularity in contingent convertibles has also grown with the stability of the banks issuing them.

Contingent Convertibles vs. Vanilla Convertibles

There is a significant difference between contingent convertibles and regular or plain vanilla convertibles. Convertible bonds have bond-like characteristics, in that they pay a regular rate of interest and have seniority in case of default. They also give the holder the ability to participate in share price appreciation by allowing conversion to common shares at a certain strike price. In other words, the bondholder receives stock in exchange for the bond at a time when the stock price is going up. In fact, the bondholder can only convert to common shares once the share price reaches a certain point. Investors like to buy stock in a company with rising share prices.

Contingent convertibles offer investors a different scenario. The logic behind contingency convertibles is somewhat inverted. Instead of converting bonds to common shares based solely on stock price appreciation, investors in contingent convertibles agree to take equity in exchange for debt when the bank's capital ratio falls below a certain point.

For example, a bank may issue contingent convertibles with a trigger set to core Tier 1 capital instead of a strike price. If core tier one capital falls below 5 percent, the convertibles automatically convert to equity and the bank has higher capital ratios. In other words, you receive common shares when the bank needs to convert debt to equity as capital thresholds become too high. This may not be an ideal time to purchase the stock. At the same time that the conversion happens, dividend payments are canceled, limiting capital distributions. In this way, contingent convertibles can seem like an upside down investment to the average convertible bond investor.

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