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Contingent Convertible



Definition

A Contingent Convertible (CoCo) is a specific type of bond that can be converted into equity shares of the issuing company under specific conditions, usually when the bank’s capital falls below a certain level. CoCos are designed to help banks absorb losses and maintain their capital adequacy ratio, a key measure of financial stability. These bonds are part of the broader category of convertible bonds but have specific triggers related to the bank’s capital levels.

Phonetic

The phonetics of the keyword “Contingent Convertible” are: Contingent: /kənˈtɪndʒənt/Convertible: /kənˈvɜːrtəbəl/

Key Takeaways

<ol><li>Contingent Convertible bonds, also known as CoCo bonds, are a type of debt instrument that converts into equity or is written off if a predefined trigger event occurs. These events are usually linked to the deterioration of the issuing financial institution’s capital position, providing a safety mechanism to mitigate financial stress. </li><li>These bonds act as an automatic stabilizer, enhancing an institution’s resilience and protecting taxpayers in the event of a crisis. The conversion or write-off mechanism provides additional capital at a time when the institution is under stress, reducing the need for governmental intervention. </li><li>Despite their potential benefits, CoCo bonds also carry risks. Investors face uncertainty as to whether conversion will trigger and the subsequent values of their investments should conversion happen. Moreover, the complexity and diversity of CoCo bond structures might lead to potential mispricing, and challenges in risk assessment. </li></ol>

Importance

Contingent Convertibles, also known as CoCos, are an important concept in business and finance as they are a form of convertible bond with a built-in mechanism designed to absorb losses when the capital of the issuing bank falls below a certain level. This feature can directly strengthen the firm’s capital base and overall financial stability, making them attractive to banks, particularly in times of financial crisis. Furthermore, they also provide potential benefits to investors such as higher yields compared to other debt securities and the potential for upside gain if the issuer’s stock price increases. However, they also tend to carry a high level of risk due to their convertibility features, which could potentially lead to substantial losses. Nevertheless, their importance cannot be overstated as they play a crucial role in maintaining the financial health of banking institutions and enhancing the stability of the overall financial system.

Explanation

A Contingent Convertible (CoCo) bond is a debt instrument that serves a significant purpose in maintaining the financial health of a company, especially financial institutions. The primary purpose of CoCo bonds is to act as a safety net or automatic stabilizer that prevents the perilous descent of the company into insolvency. This is particularly important for banks, as it helps to secure their financial stability in unanticipated downturns, ward off potential bankruptcy, and hence, protect the broader financial system and economy from any domino effect.Further, Contingent Convertible bonds are also used by financial institutions as a strategic tool to meet their capital requirements as stipulated by regulatory bodies. When a bank’s capital levels fall below the predefined levels, these bonds automatically convert into equity, therefore boosting the bank’s capital ratio and acting as a buffer to absorb losses. They provide banks with flexibility to manage their capital structure effectively. The conversion thus reinforces the capital base of a bank, instilling confidence in its financial stability among investors.

Examples

Contingent convertible bonds, often referred to as “CoCos,” are debt instruments used by financial institutions to improve their loss absorption capacity. Essentially, they are bonds that can be converted into equity or written off if a specified trigger event occurs, usually relating to the firm’s capital levels. Here are three real-world examples of their use:1. Lloyds Banking Group: In 2009, during the aftermath of the global financial crisis, UK-based Lloyds Banking Group issued £9 billion of contingent convertible securities to help improve its capital position. The CoCos were set to convert into equity if the bank’s capital ratio fell below a certain level.2. Credit Suisse: In 2011, as part of a capital raising strategy, Swiss bank Credit Suisse issued $2 billion worth of CoCos. This issuance was the first of its kind in the viable capital market, and the CoCos were designed to convert into common shares if the bank’s capital levels fell below a predetermined threshold.3. Barclays Bank: In 2013, Barclays raised £5.8 billion through the issuance of new shares, but part of this capital raising included a £2 billion issue of contingent convertible bonds. The bonds were set to automatically convert into equity if Barclays’ Tier 1 capital ratio fell below 7%.

Frequently Asked Questions(FAQ)

What is a Contingent Convertible?

A Contingent Convertible (CoCo) is a type of bond that can be converted into equity or written off if a pre-specified trigger event occurs, usually when the issuer’s capital or solvency level falls below a certain threshold.

When do Contingent Convertibles convert into equity?

The conversion of Contingent Convertibles into equity usually happens when the issuer’s capital or solvency level falls below a certain predetermined threshold. The exact terms and conditions can be found in the bond’s prospectus.

What is the purpose of a Contingent Convertible?

The main purpose of issuing CoCos is to provide a self-absorbing mechanism for the issuer, typically a bank, to strengthen its capital base. CoCos are part of the issuer’s Tier 1 capital once converted or written off.

What are the risks involved in investing in Contingent Convertibles?

The primary risk of investing in CoCos is the possibility of conversion into equity, which could dramatically decrease the investment’s value. Additionally, there’s the risk that the bond could be written off entirely. Also, the issuer has the potential not to pay coupons in case of financial stress.

What are the benefits of Contingent Convertibles?

For investors, CoCos often offer higher coupon payments compared to other types of bonds to compensate for the additional risks. For issuers, especially banks, they provide a way to strengthen their capital base in a cost-effective manner.

Are Contingent Convertibles treated as debt or equity?

While CoCos are issued as debt, they can convert into equity if certain conditions are met. Therefore, they can be considered as a hybrid of both debt and equity.

How can an investor determine if a Contingent Convertible is a good investment?

Like with any investment decision, it’s important to understand the risks and rewards associated. Potential investors should analyze the issuer’s financial health, the trigger conditions for conversion, the potential for lost interest payments, and the level of returns compared to the significant risk.

Can a Contingent Convertible be converted back into a bond once it’s been converted to equity?

Generally, once a CoCo has been converted into equity, it cannot be converted back into a bond. Every CoCo, however, comes with its own set of terms and conditions that details the actions and events around conversion.

Related Finance Terms

  • Coco Bonds
  • Basel III
  • Capital Adequacy
  • Equity Conversion
  • Financial Stability Board (FSB)

Sources for More Information


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