Convertible contingent bond (CoCo)
A contingent convertible bond (CoCo) is a fixed income financial asset whose characteristic is that it may be forced to be converted into shares if its issuer hits a series of previously specified contingencies.
Convertible contingent bonds (CoCos) belong to the family of convertible bonds. The latter are characterized by having a right for the investor to transform the convertible bonds in his portfolio into shares.
There are three types of convertible bonds, the classic ones, the compulsory convertible ones and the convertible contingents (CoCos). In the classics, the conversion right is on the investor's side. The convertible bond issuing company offers investors a conversion price, which they will accept or not, depending on their maturity, growth expectations, offered price, etc. In compulsory convertibles, on the other hand, the investor is obliged to become a shareholder.
In the case of contingent convertible bonds (CoCos), the two previous cases appear. They behave like classic convertibles, but can become forced conversion if a series of conditions (contingencies) are met. If there are a series of negative contingencies for the company (specified in the issuance prospectus), these would be forced to convert into shares.
At what point is the obligation to convert the bond into action in the CoCos established? It is decided by the company, since the convertible bond includes a right precisely to be able to carry out that conversion. Thanks to this, the company can improve its solvency.
Advantages of convertible contingent bonds
The advantages of convertible bonds are as follows:
- Due to the risk of conversion in the hands of the issuer, an attractive fixed interest is established in the issue.
- In the order of priority, the CoCos continue to be above the shares (before the conversion), so in a hypothetical bankruptcy, the investors of the CoCos would be charged first than the company's own shareholders.
Disadvantages of convertible contingent bonds
However, these bonuses also have disadvantages:
- The fact that they receive a higher return is the consequence that CoCos bear a higher risk.
- CoCos can be interesting in times of expansion of the economy (and of the company itself), since while it progresses, it will not execute its right to convert to shares. On the other hand, if the economic context is unstable, owning contingent convertible bonds may pose a risk for the investor, since if the company experiences difficulties it may force to convert at a lower price than the bondholder would be willing to convert, in the case of classic convertible bonds.
Once the bonds have been converted they go down in the order of priority as they become common stocks.
Generally, when conversions take effect, the company's share price goes down.
Why does this happen? Because the number of shares in circulation is greatly increased, which causes an excess supply, and consequently a decrease in the share price.