LO 59.7: Describe the mechanics of contingent convertible bonds (CoCos) and explain the motivations for banks to issue them.
Contingent convertible bonds (CoCos), unlike traditional convertible bonds, convert to equity automatically when certain conditions are met. These bonds typically convert to equity when the company or bank is experiencing financial strains. The motivation for banks to issue CoCos is that during normal financial periods, the bonds are debt and thus do not drag down return on equity (ROE). However, in periods of financial stress, the bonds convert to equity, providing a cushion against loss, which helps prevent insolvency. The needed capital is provided by private sector bondholders rather than the government, allowing the bank to avoid a bailout.
Potential triggers that activate conversion are: The ratio of Tier 1 equity capital to risk-weighted assets. For example, Credit Suisse
issued CoCos in 2011. Conversion is triggered if Tier 1 equity capital to risk-weighted assets falls below 7%. Supervisors judgment about the issuing banks solvency prospects. For example, the Credit Suisse CoCos automatically convert if bank supervisors determine that the bank needs public sector aid (i.e., equity capital) to avoid insolvency.
A minimum ratio of a banks market capitalization to its assets. Market value triggers
may reduce balance sheet manipulations (as one might see if the ratio of capital to risk-weighted assets is used as a trigger) but might instead introduce stock price manipulation.
2018 Kaplan, Inc.
Topic 59 Cross Reference to GARP Assigned Reading – Hull, Chapter 16
Because of the increased pressure on banks to maintain higher capital levels under Basel III, it is estimated that more than $1 trillion of CoCos will be issued between 2010 and 2020.
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