Contingent capital or contingent convertible bonds (‘CoCos”) are debt instruments with the special feature that they will be written-off to zero, or mandatorily converted into ordinary shares of the issuer, usually banks or insurance companies, when one or more triggers are met. Such a trigger could include reaching a certain threshold in the required capital ratio or “non-viability” triggers such as failure to repay a liability when it falls due. In this regard CoCos are, in effect, capital insurance bonds, similar to catastrophe insurance bonds.
The main purpose of CoCo’s is to increase the issuer’s capital in times of distress in order to try to protect depositors in the bank or policy holders in an insurance company. If the trigger is never met, CoCos are normal debt instruments which can count towards a bank's (or insurer’s) subordinated debt or Additional Tier 1 (AT1) capital, provided the relevant regulator approves it. The requirement for banks to issue CoCo’s was contained in the Basel III rules, which came into effect in January 2013, with different bank regulators in different countries having different rules about how CoCos are structured to qualify as capital, what constitutes a trigger event and what proportion of capital can be in the form of CoCos compared with more traditional regulatory capital.
Typically investors in a debt instrument rank ahead of ordinary shareholders in a winding up and they could expect to receive a higher payout than ordinary shareholders. Holders of CoCos, on the other hand, will either rank equally with shareholders (as their CoCos will be compulsorily converted into ordinary shares) or in some CoCo offers, CoCo holders can actually rank behind ordinary shareholders and incur the first loss if they are completely written off under a trigger event which only impacts the CoCo and not the shares.
For example, British bank Barclays issued CoCo securities several years ago where investors could lose all their CoCo debt investment if Barclays’ Common Equity Tier 1 (CET1) capital ratio falls below 7% of risk-weighted assets. This could result from large write downs in the loan book that could reduce the capital ratio to say 6.5% resulting in a total loss by CoCo debt holders but in such a scenario Barclays could remain viable, undertake a fresh capital raising and the ordinary shares could still have value.
In Australia all bank and insurance hybrid securities and subordinated debt securities issued since January 2013 are CoCo securities because they have contingent conversion clauses. For Australian hybrids the trigger events for conversion to equity are if the bank’s CET1 ratio falls below 5.125% or the banking and insurance regulator APRA determines, in its absolute discretion, that the bank or insurer is “non-viable”. There is no definition as to what constitutes “non-viability” and recent bank wind-ups in Spain and Italy, that were triggered by banking regulators, caught investors in the CoCo securities by surprise resulting in a total loss of their investments.
It should also be noted that even though Australian CoCo securities are typically structured to automatically convert into ordinary shares in the event of a trigger event, there is a cap on the maximum number of shares that they can convert into, meaning that if the share price was very low or worthless, the conversion into ordinary shares would still likely result in substantial losses for CoCo investors.
Investors in CoCo instruments issued by banks and insurers may sometimes believe that CoCo securities are similar to more traditional, higher-ranking debt securities when, in fact, these investor are providing contingent equity or capital insurance to the financial institution. Therefore CoCo investors need to ensure that they understand the additional risks and ensure that they are being adequately compensated for these risks.