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Fixed income
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 $US 230 billion1 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” in this opinion piece).
Today, European-domiciled issuers (mostly banks but also a small number of insurance companies) make up over 85% 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 2023, 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.
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Endnotes
1 The value is denominated in the country’s local currency.
2 Source: ICE BofA Contingent Capital Index, 31 October 2023.
3 Morgan Stanley, 30 September 2023.
The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance does not predict or guarantee future results. Investing involves risk; principal loss is possible.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. For term definitions and index descriptions, please access the glossary on nuveen.com. Please note, it is not possible to invest directly in an index.
Important information on risk
All investments carry a certain degree of risk, including possible loss of principal, and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, tax risk, political and economic risk, and income risk. As interest rates rise, bond prices fall. Preferred securities are subordinate to bonds and other debt instruments in a company’s capital structure and therefore are subject to greater credit risk. Certain types of preferred, hybrid or debt securities with special loss absorption provisions, such as contingent capital securities (CoCos), may be or become so subordinated that they present risks equivalent to, or in some cases even greater than, the same company’s common stock. Non-U.S. investments involve risks such as currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets. This report should not be regarded by the recipients as a substitute for the exercise of their own judgment. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.
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