Contingent Convertible Bond

After 2008, taxpayers bailed out banks because their bonds couldn't legally absorb losses while the bank was still alive. Regulators' answer: force banks to issue bonds that turn into loss-absorbing capital automatically, before failure. The contingent convertible — CoCo, formally Additional Tier 1 (AT1) — is that instrument.

In good times a CoCo behaves like a high-yield bond from an investment-grade bank: coupons of 6–10%, far above the same bank's senior debt. The premium exists because of what's written in the small print. If the bank's capital ratio falls through a trigger, the bond either converts into shares or is simply written down — possibly to zero. No default, no court, no vote: the contract executes itself.

Two more traps justify the fat coupon: the bank may cancel coupons at its discretion without defaulting, and the bond is perpetual — it never has to be repaid, only may be repaid at call dates.

The contractual machinery

The trigger is mechanical, set on the bank's common equity ratio:

On breach, one of two loss-absorption mechanisms fires, fixed at issuance:

• Equity conversion: bond converts to shares at a preset or floored price — holders are diluted shareholders of a troubled bank.
• Write-down: principal is written off, permanently or (rarely, in theory) with a possibility of write-up. Most Swiss and many EU CoCos chose this harsher variant.

Beyond the mechanical trigger sits the PONV clause — "point of non-viability": the regulator can impose loss absorption whenever it judges the bank non-viable, regardless of the reported ratio. This discretionary trigger, not the CET1 formula, is the one that has actually fired.

Structure of a typical AT1

• Perpetual, callable from year 5–10 and regularly thereafter; if not called, the coupon resets to the prevailing swap rate plus the original issue spread.
• Fully discretionary coupons, blocked automatically if the bank breaches its capital-distribution thresholds (MDA) — coupons compete with dividends and bonuses for the same payout capacity.
• Deeply subordinated: below Tier 2, above only common equity — in theory.

Valuation: yield-to-call, extension risk and the reset

An AT1 quotes as a portfolio of scenarios: called at the next date, or extended perpetual at the reset spread. The market convention prices to worst:

Extension risk dominates the rates leg: when credit spreads blow out past the reset spread \(s_{\text{reset}}\), calling and refinancing costs the bank more than extending — so precisely when markets sour, expected maturity lurches from 1–2 years to perpetual and duration extends violently (the 2023 repricing added years of spread duration to the index in a week). Banks nonetheless usually call, paying up to protect refinancing goodwill — Santander's 2019 non-call, the first by a major issuer, cost holders points and the issuer little.

Modelling the loss absorption

Structural models treat the trigger as a barrier on the (unobservable) capital ratio: the CoCo is a bond short a down-and-in claim on bank equity — a knock-in written on an accounting number that management itself reports, with a regulatory option (PONV) layered on top. Practical consequences:

• Accounting barrier ≠ market barrier: CET1 ratios move slowly and are managed; market-based distance-to-trigger (equity price, sub-debt spreads) leads reported ratios by quarters. Credit Suisse's last reported CET1 was 14.1% — nearly triple its trigger — the week it died.
• Death-spiral debate: conversion CoCos with floored conversion prices can incentivise equity shorting as the trigger nears; write-down CoCos avoid dilution mechanics but destroy the creditor hierarchy instead.
• Coupon-cancellation option: an MDA breach stops coupons with no cure — modelled as a series of digital options on the capital-buffer path; the 2016 Deutsche Bank scare traded this leg alone, with AT1s dropping 10+ points on coupon fear without any trigger risk repricing.

After Credit Suisse

The EU and UK regulators publicly re-committed to equity absorbing losses first in their jurisdictions — re-anchoring the hierarchy contractually broken in Switzerland — and the market reopened within months, at wider spreads and with investors finally reading the prospectus section titled "Risk of write-down". Documentation basis (Swiss-style permanent write-down vs. EU conversion) now prices explicitly.

The formulas above are standard textbook formulations, simplified for teaching. They explain the mechanism — they are not a valuation tool, and they will not reproduce a dealer’s price.