During the 2008 financial crisis, numerous banks faced capital strains. Many governments have stepped in to restore the banking sector with taxpayers’ dollars. As a result, many new regulations were published and imposed to improve the resilience of the banking sector, particularly for the strengthening of banks’ capital base.
As a result of the higher capital requirement from new regulations, e.g. Basel III standard, a new type of convertible bond instrument became popular among banks — the contingent convertible bond, which is also known as CoCo.
CoCo is a hybrid form of financing instrument, containing features of both debt and equity. It has fixed remuneration feature like typical debt, together with a loss absorbing capacity of an equity. It is usually issued by banks as a subordinated bond which pays a coupon, and it can be either converted into common equity or written down when certain contractually specified events occur. Such triggering events are commonly designed against banks’ regulatory capital ratio.
A traditional convertible bond is converted to common shares in the event that the underlying share price appreciates beyond a pre-determined threshold level, upon investors exercising their rights. In contrast, for CoCo bond, it is automatically converted into common equity or written down when the bank’s capital ratio falls below a pre-set level. With this mechanism, the issuing bank capital level can be boosted up to meet the regulatory requirement. Due to the abovementioned mechanism, CoCo is considered a relatively risky security, and usually comes with an attractive yield of around 5%-7% p.a.
As of 2014, issuance levels reached close to $170 billion globally.