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 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 1 contingent convertible bonds are an ideal product for undercapitalized banks in markets around the globe since they come with an embedded option 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 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 must return to investors if the bank experiences financial hardship it can postpone the payment of interest force a conversion to equity or in dire situations write the debt down to zero u s banks issue preferred stocks instead of cocos to meet at1 capital requirements benefits and risks of cocos for investorseuropean 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 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 convertiblelet 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 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 the swiss government brokered the deal to contain a spreading crisis of confidence in global financial markets the deal triggered a total write down 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 