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Understanding contingent capital securities (CoCos)
Contingent capital securities, sometimes called contingent convertibles (CoCos), have evolved from niche status to become a well-developed segment of the global fixed income markets. Strong issuer credit fundamentals, meaningful income generation and an attractive risk/return profile have resulted in broad adoption of the asset class. Liquidity has increased over the years and the CoCo market has grown to near its terminal size (or maximum required capital amount for existing banks). Today, the CoCo market has over 239 billion (local currency1) in face value of securities outstanding, representing nearly 100 different issuers and spanning multiple currencies.2 In the pages that follow, we provide an overview and analysis of the asset class, as well as our insights on the important role CoCos can play in fixed income portfolios.
What are CoCos?
CoCos are hybrid securities created by regulators after the 2007-08 global financial crisis (GFC) as a way to reduce the likelihood of government-orchestrated bailouts. Issued primarily by non-U.S. banks, CoCos are designed to automatically absorb losses, thereby helping the issuing bank satisfy Additional Tier 1 (AT1) and Tier 2 (T2) regulatory capital requirements (as described under “capital structure position” below).
Today, European-domiciled issuers (mostly banks but also a small number of insurance companies) make up almost 80% of the outstanding CoCo market. Insurance companies may use these securities for capital purposes or to help manage their credit ratings.
But why are CoCos “contingent”? Because of a feature that automatically imposes a loss on the investor should an issuer’s capital fall below a predetermined threshold — typically 7% of its total risk-weighted assets in a “high trigger” structure and 5.125% in a “low trigger” structure. When this occurs, depending on the structure, there are three possible outcomes:
- The security is converted to common equity
- The investor is forced to assume a temporary writedown of the security’s value
- The investor is forced to assume a permanent writedown of the security’s value
As of September 2022, minimum regulatory capital requirements for European banks were well above the high- and low-trigger CoCo thresholds, and most banks hold capital far in excess of the required minimum level.3
In the U.S., banks issue preferred stock rather than CoCos to fulfill their AT1 capital requirement. The main difference between a preferred stock and an AT1 CoCo, besides the issuer’s likely geography, is that only the CoCo has the contingency feature described above. In fact, because CoCos and preferred stock play nearly identical roles and rank similarly within an issuer’s capital structure — i.e., lower than senior debt but higher than common equity — CoCos are commonly held in strategies that invest in preferred stocks.
1 The value is denominated in the country’s local currency.
2 Source: ICE BofA Contingent Capital Index, 31 October 2022.
3 Morgan Stanley, 30 September 2022.