What are the CoCos that everyone is talking about?

Known in financial jargon as AT1 (Additional Tier 1) bonds, Contingent Convertible bonds (CoCos) are a type of subordinated debt issued by banks to strengthen their capital in times of lack of solvency or sector shocks. Their structure is designed to absorb losses, making them a hybrid financial product that blends the features of fixed income (debt) and equity (stocks).

They are termed 'convertible' because they can transform from debt to equity, and 'contingent' because this transformation occurs only if the issuer’s solvency drops below a certain threshold. The conversion may be mandatory or discretionary, depending on the contract's terms, and can result in new securities or complete amortization.

However, this conversion is a double-edged sword, as it can occur during periods of market uncertainty and volatility, potentially diminishing their value and leading to a total loss. 

Another risk of these products is their subordinated structure, which places bondholders behind other creditors in priority for repayment. Consequently, the risk of non-repayment is one of the primary concerns to consider. In the recent case of Credit Suisse, CoCo holders did not recover their investment after the new owner decided against the conversion.

Another distinctive feature of AT1 bonds is their perpetuity; they do not have a fixed maturity date. The issuer may redeem the bond at its convenience, typically within five years. 

Adhering to the investment principle that higher risk brings the potential for higher returns, Contingent Convertible Bonds offer a yield superior to that of traditional bonds. This yield remains fixed over the bond's tenure, with the payment of a predetermined coupon assured from issuance until the bond is mandatorily converted into equity. Furthermore, should the underlying shares perform well, the conversion could lead to potential long-term gains increases.

It is estimated that the global issuance volume of CoCos is 250 billion euros, according to data from March. At Credit Suisse alone, more than 16 billion euros were invested in this product. In Spain, at the end of the first quarter, the outstanding balance was approximately 22 billion euros, according to calculations by Europa Press. In Latin America, S&P dismissed any impact on regional banking.

As can be observed, they are a highly complex instrument. Indeed, the European Securities and Markets Authority (ESMA) classified them as "risky products" for savers a few years ago. Consequently, the purchase of these bonds is limited to qualified and institutional investors, with sales to retail clients prohibited.

This instrument was created in 2008, following the financial crisis that led to the collapse of numerous financial institutions, including the legendary giant Lehman Brothers, to ensure the system's liquidity. However, for holders, it is an illiquid product with uncertain returns.