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Contingent Convertibles

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It’s a high-yield investment with a hand grenade attached. An asset carried gingerly with the hope that it won’t explode, leaving investors in a hole. Welcome to a class of securities tailor-made for banks that’s become popular in Europe: contingent convertibles, also known as CoCo bonds. A cross between a bond and a stock, CoCos are helping banks bolster capital to meet regulations designed to prevent a repeat of the taxpayer bailouts of the 2008 financial crisis. Some investors are skeptical that the extra yield CoCos offer really reflects their dangers, but about 200 issues worth more than a combined 180 billion euros ($212 billion) have been snapped up since they first came to market in 2013. While CoCos are supposed to make financial markets safer, critics question whether regulators have unwittingly created new risks.

CoCos were tested again as the coronavirus roiled markets, pushing yields to a record of almost 15% in March 2020 as fears grew that interest payments could be skipped. They largely recovered in the months that followed, thanks to regulatory restrictions on dividends to preserve cash and relief measures that are helping boost banks’ capital buffers. New sales halted for nearly three months before resuming in May. It was the market’s biggest challenge since 2017, when Banco Popular Espanol SA, Spain’s sixth-biggest bank, was swallowed by rival Banco Santander SA to prevent its collapse. The takeover wiped out 1.25 billion euros worth of Popular’s CoCos. The CoCos sold since 2013 are used to raise Additional Tier 1 (AT1) capital, a lender’s first line of defense after equity against financial shocks. While hedge funds seeking higher yields are keen buyers, the bonds are also purchased by asset managers hungry for income in a low interest rate environment. In mid-2020, major currency CoCos sold during the year paid a coupon of between 3.375% and 7.5%, roughly double or even triple that of more secure senior bank bonds.