Contingent Convertibles (CoCos)
CoCos are bank-issued bonds that automatically convert into equity or get written down when the bank's capital falls too low, transferring losses to bondholders before taxpayers or depositors are at risk.
Prerequisites: Why Companies Issue Convertible Bonds
After 2008, regulators wanted banks to hold securities that behave like debt in good times — paying interest, not diluting shareholders — but automatically absorb losses in bad times, before a government bailout is needed. Contingent convertibles, or CoCos, were the answer: bonds that convert into equity, or get written down to zero, the moment the bank's capital ratio drops below a pre-set trigger.
A CoCo pays a bond coupon right up until the issuing bank's capital gets dangerously thin, at which point it flips — either converting into shares or being wiped out — turning what looked like debt into a loss absorber exactly when the bank needs one.
How the trigger works
Every CoCo specifies a trigger tied to the bank's regulatory capital ratio (commonly Common Equity Tier 1, or CET1, as a percentage of risk-weighted assets) — a typical trigger is 5.125% or 7%. As long as the ratio stays above the trigger, the CoCo behaves like an ordinary bond: it pays a coupon, usually a high one to compensate for the risk, and trades near par. If the ratio breaches the trigger, the CoCo does one of two things depending on its design:
- Conversion to equity — bondholders receive shares, usually at a price set when the CoCo was issued, diluting existing shareholders but keeping bondholders with some residual value.
- Write-down — the bond's principal is reduced, sometimes to zero, with nothing given in return. This is more severe for the bondholder than conversion.
Worked example
A bank issues $1 billion of CoCos with a 7% CET1 trigger and a 6% coupon, in a write-down structure.
- Good times: the bank's CET1 ratio sits at 12%. The CoCo pays its 6% coupon — $60 million a year — and trades close to $1,000 per $1,000 face bond, like any other subordinated bond.
- Stress hits: loan losses push CET1 down to 6.5%, below the 7% trigger. The write-down provisions activate, and the bond's principal is cut — say, by 50% — instantly turning a $1,000-face bond into a $500 claim, with coupons stopping.
- Why the bank benefits: that $500 million of lost bondholder value flows straight into the bank's capital position, since the bank no longer owes that money — the CoCo did its job, absorbing losses and boosting the bank's capital ratio right when it was falling.
What this means in practice
Regulators like CoCos because they push loss-absorption onto sophisticated bond investors rather than depositors or taxpayers, and they let a bank count CoCos toward its regulatory capital requirements while still paying a market coupon in normal times. Investors demand a much higher yield than plain subordinated debt for exactly this reason — buying a CoCo means underwriting the risk that the issuing bank hits real trouble, not just that it defaults outright.
CoCos can convert or write down well before a bank actually fails — the trigger is a capital ratio, not insolvency. In the 2023 collapse of a major European bank, CoCo holders were wiped out to zero while some equity holders retained partial value, reversing the usual seniority order investors expect and showing that CoCo documentation, not intuition, decides who loses first.
Further reading
- BIS, 'Contingent Convertible Bonds and Bank Solvency'