Contingent Convertibles (CoCos): Definition, Uses, Benefits, and Risks

What are CoCos?

Contingent convertibles (CoCos), also called AT1 bonds or enhanced capital notes (ECNs), are hybrid debt instruments predominantly issued by European banks. They pay higher-than-average interest but include pre-set mechanisms that convert the debt into equity or write it down if the issuing bank’s capital falls below specified thresholds. CoCos were developed after the 2007–2008 financial crisis to strengthen banks’ loss-absorbing capacity and reduce the need for taxpayer-funded bailouts.

Key points

• CoCos are debt securities that convert to equity or are written down when predefined triggers are hit.
• They serve as Additional Tier 1 (AT1) capital under Basel III to help banks meet regulatory capital requirements.
• Investors receive higher yields in exchange for elevated risk, including possible loss of principal if triggers occur.
• CoCos are common in Europe; U.S. banks typically use preferred stock for similar regulatory purposes.

How CoCos work

Trigger mechanisms: Triggers vary by issue and can be linked to the bank’s capital ratios (e.g., core Tier 1), the market price of the bank’s shares, or a supervisory authority’s judgment. Typical trigger points cited in industry examples are around 5%–7% of risk-weighted Tier 1 capital.

Conversion outcomes: When a trigger is hit, one of three outcomes (or a combination) usually applies:
* Automatic conversion to common shares at a preset conversion rate or market price.
Temporary write-down (partial reduction in principal value).
Permanent write-down (full or partial cancellation of principal).

Unlike ordinary convertible bonds, CoCos are designed primarily to absorb losses for the bank rather than to give investors upside if the stock appreciates.

Regulatory purpose and background

Basel III tightened bank capital rules after the global financial crisis, requiring higher-quality loss-absorbing capital. CoCos qualify as AT1 capital and help banks meet these requirements by automatically shifting liabilities into equity (or reducing liabilities) during stress, thereby protecting solvency and reducing the need for external rescue.

How banks use CoCos

Banks issue CoCos to bolster regulatory capital without immediately diluting shareholders. CoCos can:
* Raise capital while allowing interest payments to continue in normal times.
Be converted or written down automatically when capital metrics deteriorate, improving regulatory ratios.
Provide flexibility: interest payments can be suspended and principal need not mature on a fixed date, depending on terms.

Investor perspective: benefits and risks

Benefits
* High yields relative to standard bank bonds or corporate debt.
* Potential upside if conversion is triggered at a favorable price (rare in practice).

Risks
* Loss of principal through temporary or permanent write-downs.
Conversion into equity often occurs when the bank is in distress, meaning shares received may be deeply depressed in value.
Limited seniority: CoCos are subordinated to many other creditors.
Liquidity and regulatory constraints can make selling CoCos difficult in stressed markets.
Contractual terms vary widely; investor outcomes depend heavily on specific issue language.

Example (simplified)

An investor holds a CoCo with a face value of $1,000 paying 8% annually. A trigger tied to Tier 1 capital is breached and the instrument converts into 25 shares. If the bank’s share price has fallen from $100 to $40, those 25 shares equal $1,000 — but if the share price subsequently falls to $30, the holding falls to $750 (a 25% loss). Conversion during distress therefore often crystallizes losses.

Notable market event

The 2023 Credit Suisse–UBS transaction highlighted CoCo risks when certain AT1 instruments were written down as part of the rescue. That event prompted debate about the hierarchy of loss absorption and reinforced that CoCos can experience severe, sudden losses in systemic stress.

How CoCos differ from standard convertible bonds

• Purpose: Standard convertible bonds are typically investor-friendly financing instruments that allow bondholders to convert into equity to capture upside. CoCos are designed primarily to protect bank solvency by absorbing losses.
• Triggers: Convertible bonds convert at the holder’s option (often based on stock price); CoCos convert or write down on preset regulatory or supervisory triggers.
• Seniority and yield: CoCos are generally more subordinated and pay higher yields to compensate for greater risk.

What happens to CoCos in a crisis?

In periods of financial stress, CoCo prices can fall sharply. If a bank’s capital falls below trigger levels, interest payments may be suspended and holders may be forced into equity or face partial/complete write-downs. Because conversion tends to happen when share prices are weak, investors often absorb meaningful losses.

Conclusion

CoCos are a targeted regulatory tool that help banks meet capital requirements and absorb losses without immediate public bailouts. They offer attractive yields but carry significant downside risk, including potential loss of principal and forced conversion during periods of distress. Investors should carefully review issue terms, understand trigger mechanics, and consider CoCos only if they accept the elevated risk profile.

Further reading (select)

Sources relevant to CoCos include Basel III regulatory material, publications by the Bank for International Settlements, and issuer prospectuses for individual AT1 issues.