Key Takeaways
- CoCo bonds (contingent convertible bonds) typically offer higher yields than traditional bonds, making them attractive to income-focused investors.
- Adding CoCos to a portfolio can enhance diversification and improve overall risk-adjusted returns.
- If a bank’s capital ratio falls below a certain threshold, CoCos convert into equity or are written down, helping stabilize the financial system.
- Investors should understand both the potential benefits and the risks before investing in CoCos.
Building Steady Income with Bonds
Adding bonds consistently to your portfolio is a way to prepare yourself for retirement, as bonds provide a steady and predictable source of income.
One type of bond worth considering is a Contingent Convertible Bond (CoCo), sometimes called a CoCo bond or bank hybrid instrument, because they typically offer higher coupons (income) than other fixed-income securities.
CoCos are hybrid bonds with unique characteristics and special terms that set them apart from traditional bonds. The higher coupon compensates investors who are willing to navigate the added complexity in exchange for potentially greater returns.
How Contingent Convertible Bonds Work
CoCos are issued primarily by financial institutions and are redesigned to absorb losses while helping banks maintain their capital ratios during periods of financial stress.
The defining feature of CoCos is their conversion mechanism. They can convert into equity or be written down when a predefined trigger event occurs. These triggers are typically tied to a bank’s Common Equity Tier 1 (CET1) capital ratio.
If the CET1 ratio falls below a certain threshold, the CoCos automatically convert into equity or have their principal reduced, providing immediate capital relief to the bank. This makes them valuable for both issuers and regulators aiming to safeguard financial stability.
Types of CoCos and Conversion Triggers
CoCos can be classified into two main types based on how conversion is triggered:
- Mechanical triggers: Automatic conversion when specific financial metrics (such as the CET1 ratio) fall below a set level.
- Discretionary triggers: Conversion or write-down decided by a regulatory authority in response to broader market stress.
These mechanisms make CoCos different from other bonds. They are both debt and equity in nature, sitting between subordinated bonds and ordinary shares in the capital structure.
To learn more about where CoCo bonds fit into the capital structure, explore our blog “Loco for COCO bonds”
Benefits of Adding CoCos to Your Portfolio
Beyond offering higher income, contingent convertible bonds can enhance portfolio diversification. Because they respond to banking sector dynamics rather than the broader economic cycle, they behave differently from corporate or government bonds.
CoCos have a different risk-return profile compared to other fixed-income securities. This different risk-return profile can help smooth portfolio volatility and improve long-term, risk-adjusted returns.
CoCos also carry the potential for capital gains. CoCos can provide capital gains if the issuing bank performs well and the perceived risk of conversion decreases. These factors can lead to an appreciation in the bond’s market price.
Another key benefit is regulatory support. CoCos are often seen favorably by regulators, as they help banks shore up their capital without diluting existing shareholders until absolutely necessary. This structural backing can provide investors with additional confidence in these securities.
CoCos vs Traditional and High-Yield Bonds
Compared with traditional bonds or high-yield junk bonds, contingent convertible bonds can provide higher income and a unique form of risk exposure.
Typically, lower-rated companies issue high-yield bonds, despite their elevated returns. CoCos, on the other hand, are issued by high-quality banks, giving investors access to stronger credit quality and a more diversified fixed-income mix.
In summary:
- Higher yield: CoCos often pay more than investment-grade or government bonds.
- Diversification: They behave differently from both corporate and sovereign debt.
- Quality exposure: They come from major financial institutions, not speculative issuers.
Risks to Keep in Mind
While CoCos offer attractive benefits, they also carry important risks. The main risk is conversion into equity or a principal write-down, which can lead to losses for bondholders if the issuing bank’s financial condition deteriorates.
Additionally, CoCos can be more volatile than traditional fixed-income securities, especially during market stress or banking sector instability.
Their complex structure also means each issue can have unique terms, triggers, and conditions. Investors should carefully weigh these advantages against the inherent risks and ensure they have a comprehensive understanding of the terms and triggers associated with these instruments. As with any financial investment, a well-thought-out strategy and diversification are key to managing risks and maximizing returns.
Frequently Asked Questions
Are CoCo bonds good for long-term investors?
CoCos can offer consistent income through higher coupons, which may appeal to long-term investors seeking yield. However, because they carry conversion and market risks, they should be included as part of a diversified strategy rather than being the core of a retirement portfolio.
How do CoCo bonds perform when interest rates rise or fall?
Unlike traditional bonds, CoCos may not move directly in line with interest rate changes. Their value often depends more on the financial strength of the issuing bank and investor confidence in the broader financial system.
Can CoCo bonds lose all their value?
In extreme situations, such as severe financial stress for the issuing bank, CoCos can be written down or converted to shares, reducing or eliminating their value. These features are designed to protect the banking system but can result in losses for investors.
Do CoCo bonds pay fixed or variable interest?
Most CoCos pay fixed coupons, although some include variable or reset features linked to market rates. Understanding the coupon structure is important for investors looking to manage income stability.
What should investors look for before buying CoCo bonds?
Check the issuer’s credit rating, conversion triggers, and capital ratios. A financial advisor can help assess whether a specific issue aligns with your goals, income needs, and tolerance for risk.
The Investor’s Takeaway
Contingent Convertible Bonds (CoCos) can help investors earn higher income while maintaining exposure to strong, regulated financial institutions. They offer diversification and the potential for better returns than traditional bonds, though they carry more complexity and risk.
For investors who understand these instruments and want to enhance their fixed-income strategy, CoCos can be a valuable addition to a well-diversified investment portfolio.
Speak with a Sterling Financial Advisor to explore how they could fit your investment goals.
From the Sterling Team
Toni-Ann Neita-Elliott, CFP is Vice President Marketing & Sales at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm
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