The Securities Litigation Expert Blog

Jack Duval Quoted in MarketWatch Article on CoCo Bonds

Posted by Jack Duval

Jan 2, 2018 10:46:12 AM

Accelerant Managing Partner Jack Duval was quoted in a MarketWatch article on contingent convertible ("CoCo") bonds.

What the article didn't mention is that Deutsche Bank and other CoCo issuers have been exploring making a market in total return swaps on CoCo's, including those issued by themselves.  If implemented, these derivitives would set up highly complex and perverse incentives where the bank (as counterparty) could profit from weakening it's own financial strength.

Banco Popular Bail-In

In a pattern that is repeated frequently in securities markets, in early- to mid-2017 Banco Popular common equity declined 80 percent while the Banco Popular 8 1/4 perpetual CoCo's only declined 20 percent.  This relationship existed until a month before the CoCo's were wiped out in the reorganization, thus "bailing-in" the bank by being completely written off.

Banco Popular CoCo v. Common Equity Chart.gif

Source: Bloomberg

Suitability of Complex Products

As I have discussed here and here, contingent convertible bonds are highly complex and subject to extraordinary risks that are not typical of traditional bonds.  They are only suitable for highly sophisticated investors who can evaluate the company specific and regulatory risks and are willing to lose their entire investment.  This eliminates virtually all retail investors and most institutional investors.

For information about securities expert Jack Duval, click here.


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Topics: Contingent Convertible Bond, CoCo, Banco Popular, Bail-in, MarketWatch

Warning: Contingent Convertible Bonds are Insurance

Posted by Jack Duval

Feb 16, 2016 8:06:02 AM

This post continues our series on insurance-liked securities ("ILS").

There has been a excessive amount of worry surrounding Deutsche Bank Contingent Convertible bonds ("CoCos") in the past week. (See our previous coverage here.)  As the weak sister in the European banking community, Deutsche Bank has been the focus of bond selling and consternation, as well it should be. The bank's stock is trading lower than during the Global Financial Crisis.

Chart 1: Deutsche Bank Stock Price Chart from 1999[1]


However, should anyone be surprised that Deutsche Bank's CoCo bonds have sold off? Absolutely not. Indeed, they have performed exactly as advertised.

So why the angst?

I believe it is another case of complexity risk. The CoCo bond structures are so complex that they have not been understood, even within the institutional investing community.

How could the sophisticated institutional investing community not understand a bond issuance? Days before the CoCo bond priced, Deutsche Bank issued a 44 page presentation to explain it's plans for strengthening it's balance sheet. I have extracted on page from that presentation below.

Chart 2: Deutsche Bank Explanation of "Comprehensively strengthening capital and leverage ratios for the longer-term"[2]


In order to understand this slide, you need to have facility with the following concepts:

Luckily, Deutsche Bank provided some footnotes to help investors understand at these regulatory items, for example:[3]

Global systemically important banks buffer may vary between 1% and 3.5%… DB currently assessed in the 2% bucket. Alternatively, a buffer for macro-prudential and /or systemic risk of up to 5% can be set by EU member states. The higher of the G-SIB buffer and this systemic risk buffer is then applicable... (the 2019 Requirements) currently excludes the potential for a countercyclical buffer of up to 2.5%… (the Adjusted Ratio) comprises fully loaded CET1, plus all current eligible AT1 outstanding (under phase-in).

Trying to figure out EU member bank capital requirements may have led to investors taking their eye off the bond prospectus. The Deutsche Bank CoCo bond prospectus disclosed a number of red flags that should have put investors on notice about the speculative nature of the debt. Some of those include:[4]

  • The bonds were rated below investment grade by S&P (BB), Moody's (Ba3), and Fitch (BB+) at issuance (P.1,7);
  • The interest payments are made (or not made) at the complete discretion of Deutsche Bank and "depend on the Issuers Available Distributable Items ("ADI")… ADI means: the profit at the end of the financial year... any profits carried forward... minus any losses carried forward, and any profits which are non-distributable pursuant to applicable law". (P.8) Thus, any hit to profits, whether from an economic slowdown, loan loses, or settlement/litigation costs from regulators or others, would put the interest payments in jeopardy;
  • Principal write-downs if Deutsche Bank's Tier 1 capital ratio fell to below 5.125% (P.11);
  • A reduction in liquidity of the Notes from any event that could result in a write-down (P.11);
  • Adverse price affects from changes in the Issuers Common Equity Tier 1 Capital Ratio (P.11);
  • No scheduled maturity date for the Notes and redemption at the sole discretion of the Issuer (P.11);

Insurance, not Bonds

Deutsche Bank's investors seem to be upset that the CoCo bonds have declined in value.[5] They should not be. CoCo bonds are a form of insurance-linked security. By purchasing them, the bond holders have chosen to insure the bank's Tier 1 capital ratio.

Once this is understood, it becomes obvious how the bonds should trade. The principal is not the bond holders, it is the "insurers" (bond holders) reserves. If the insured event comes to be (Tier 1 capital declining below 5.125 percent), the reserves go to the insured.

An insurer would be willing to make this bet in perpetuity (while adjusting premiums along the way for changes in risk). The fact that CoCo holders are now complaining about their returns shows that they are not willing to make this bet over and over and that they didn't understand it to begin with.

Chart 3: Deutsche Bank 3.7% of 24, CoCo, and Common Equity Price Chart[6]


It appears likely that the complexities of CoCos blinded buyers to the fact that they were entering the insurance business, and that they didn't know how to do proper underwriting.

CoCo bonds are only suitable for those who have the ability to underwrite insurance on complex financial entities and who understand the shifting sands of European bank regulation.  (These two criteria probably eliminate the vast majority of CoCo owners.)

As most investors learn at some point: the market is an expensive place to get an education.



[1]     Source: Bloomberg.

[2]     Deutsche Bank Investor Relations website; Available at:; Accessed February 15, 2016.

[3]     Id.

[4]     Deutsche Bank Undated Non-cumulative Fixed to Reset Rate Additional Tier 1 Notes of 2014 prospectus.

[5]     The Economist, Deutsche Bank's unappetising cocos, February 13, 2016; Available at:; Accessed February 16, 2016.

[6]     Source: Bloomberg.

 For information about insurance-linked securities expert Jack Duval, click here.


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Topics: suitability, Deutsche Bank, Complexity Risk, Contingent Convertible Bond, ILS, insurance-linked securities, CoCo

Litigation Costs May Sink Deutsche Bank Contingent Convertible Bonds

Posted by Jack Duval

Feb 9, 2016 7:48:07 AM

Guest Post by Len Santoro

Last year, European banks issued a record amount of a new type of high-risk bond meant to bolster each respective bank's Tier I capital in times of stress.  This year Deutsche Bank, which has been suffering through a lengthy restructuring and extreme litigation and settlement costs, may have to tap these bonds - wiping investors out.[1]

Deutsche Bank 6% Perpetual Contingent Convertible Bond Price Chart (Bloomberg)


These new bonds are called Contingent Convertible’s (“CoCo’s”).  They are a pre-funded source of capital meant to insure that the issuing bank maintains its Tier 1 Capital ratio if its other assets decline in value.

If a bank's assets suffer a catastrophic decline in value, the CoCo's are triggered and the capital gets transferred to the bank's balance sheet when it needs it the most, without having to go through a protracted and costly capital raise.

CoCo's can be considered a form of insurance-linked securities ("ILS") that insure against financial catastrophies (see our previous posts on ILS here and here).  CoCo's offer high yields, are highly complex, and can turn into equity or be written down to zero by the issuing banks at their discretion.

The creation and issuance of CoCo bonds goes back to the financial crisis of 2008-2009 which saw bank balance sheets destroyed by bad bets on sub-prime mortgages.  The international banking community, working through the Basel accords has been required to bolster its Tier 1 Capital.  CoCo bonds provide a buffer to an issuing bank's Tier 1 Capital.  Just like a catastrophe bond, if the issuing bank takes large losses to it's capital base, the CoCo bond gets written down for its owners and the assets are transfered to the issuer's balance sheet.

In this way, it can be thought of as insurance for the banks Tier 1 Capital ratio.

Tier 1 Capital

Tier 1 capital is comprised of common stock, retained earnings, some types of preferred stock, and certain hybrid securities such as trust preferred securities and now, CoCo’s.  It is used in the computation of a banks leverage ratio.  This ratio is calculated by dividing Tier 1 capital by total assets.

Since the global financial crisis, regulators have been working with banks to raise their Tier I capital (and thus lower their leverage).

Contingent Convertible as Tier I Capital

To qualify as Tier 1 capital, CoCo’s must meet a number of criteria, some of which include them being:

  • Unsecured;
  • Subordinated;
  • Not convertible at the holders option;
  • Having interest deferability where the profitability of the bank would not support payment.

Essentially, a CoCo is constructed to absorb losses when the bank's capital drops below certain regulatory levels.  Exactly how losses are absorbed varies by security and structure.

At issuance, CoCo’s are non-dilutive, debt servicing is subsidized by tax deductions, and, unlike traditional convertible securities, the issue is converted at the issuers discretion.  CoCo’s frequently do not have a maturity date and are typically callable every five years.  The other two key characteristics are the "trigger point" and the "lost absorption mechanism".

The Trigger Point

The trigger is the event that changes these securities from being contingent to certain.  Like ILS, CoCo triggers are very specific and are defined in the prospectus.  In practice, the trigger point is where the CoCo is partially or totally written down, or converted to stock.

Triggers can be formula- or regulatory-based and there are unique risks associated with each.  Formula-based triggers can be based on book or market value.  Book value triggers are less transparent and less timely.

Market value formula triggers have the advantage of being timely and transparent, however, they are subject to market pressures.

It's hard to imagine a situation where a trigger executed based on a regulator's decision would be preferred by the bondholder.

The Loss Absorption Mechanism

Loss absorption is simply the method through which management takes the bondholders investment.

There are two main methodologies for implementing this transfer of wealth.  One is through equity conversion and the other is through an outright principal write down of the bondholder's  investment.  Historically the loss absorption method has been evenly split between the two methods.

Equity Conversion

On the surface, equity conversion appears to be a preferential method for bondholders.  Having equity gives the bondholder some upside potential.  In addition, since equity conversion is dilutive, one can assume that management will be less motivated to implement the trigger.

However, the second part of the equity conversion method is the conversion price.  Depending on the issue, the conversion could be the market price at the time the trigger is breached or some other predetermined price.  Since a market price conversion would be dilutive, that is the most favorable to the CoCo investor.  A predetermined price conversion is less dilutive, and thus less attractive for bond investors.


Some CoCo's give the issuer the ability to write-down the bonds to zero if certain triggers are met.  In this way, they are similar to Catastrophe Bonds that have been issued by reinsurers to protect issuers against severe weather events. 

The principal write-down security is most attractive to the issuer since it is not dilutive to current shareholders.  As with most bonds, what is favored by the issuer should be avoided by the bond investor.  The danger of buying a principal write down CoCo with a "high " trigger is that the company can obtain cheap capital when the bank is still well above insolvency, all at the bondholder’s expense.

As a general rule, market price equity conversion with low triggers is most attractive while principal write-down with high triggers are the least.  As with all fixed income investments, the bondholder must recognize that they and management are adversaries.

If a Coco bond write down is executed at a relatively high trigger point, it could be a windfall for the stockholders.  In such a case, there would be a transfer of wealth from the bondholders to the stock holders when the bank is still far from insolvency.


CoCo’s have high complexity risk and are suitable only for the most sophisticated investors who are capable of understanding and evaluating their risks.  To fully evaluate the risks of a CoCo bond, an investor (or advisor) would need to understand at least the following factors:

  • Bank capital requirements and potential changes to those requirements;
  • The effect of the investment on an overall portfolio
  • Currency risks
  • The terms and provisions of the security
  • How economic and interest changes might affect the security

In the Deutsche Bank deal mentioned above, the prospectus states:[4]

The Notes may not be a suitable investment for all investors.  Potential investors must determine the suitability (either alone or with the help of a financial adviser) of an investment in the Notes in light of their own circumstances.  In particular, each potential investor should:
  • have sufficient knowledge and experience to make a meaningful evaluation of the Notes, the merits and risks of investing in the Notes...
  • have access to, and knowledge of, appropriate analytic tools to evaluate, in the context of his/her particular financial situation, an investment in the notes...
  • have sufficient financial resources and liquidity to bear all of the risks of an investment in the Notes, including the risk not to receive any return on investment or repayment of the invested amount...
  • understand thoroughly the terms of the Notes and be familiar with the behavior of the financial markets; and
  • be able to evaluate possible scenarios for econmic, interest rate and other factors that may affect his/her investment and his/her ability to bear the applicable risks.

Clearly, CoCo's are only appropriace for the most sophisticated market participants.  Furthermore, Deutsche Bank also attached a minimum lot size of the issue of $200,000, which demonstrates that it was not targeted for retail investors.[5]  (Most corporate bonds have $1,000 minimum lot sizes.)

In the current low interest rate environment, the mid-single digit percent yield on most CoCo’s is attractive[6].  However, chasing yield in CoCo bonds could end badly, especially for investors who did not understand what they were sold.

CoCo’s are only appropriate for investors who are comfortable speculating with their investments and who are prepared to see their CoCo investment wiped out if the bank issuers comes under stress.  As with all ILS, CoCo bonds should only be purchased in diversified pools and only represent a small portion of an investor’s diversified bond portfolio.



[1]      John Glover, "Deutsche Bank's Woes Threaten CoCo Coupons, CreditSights Says", Bloomberg.  Available at:; Accessed Tuesday, February 9, 2016.  For general background on CoCos, see:  John Glover, “Riskiest Bank Bond Sales Swell to Record in Europe”, Bloomberg, (October 1, 2014)

[2]           FDIC, “Optional Regulatory Capital Worksheet”,

[3]           Deutsche Bank Research, “Contingent Convertibles: Bank Bonds Take on a New Look”, May 23,2011,

[4]           Deutsche Bank 6% Perpetual Contingent Convertible prospectus, 8.

[5]        . at 5.

[6]           These yields are approximately three to four full percentage points over senior bank note bonds.

 For information about insurance-linked securities expert Jack Duval, click here.


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Topics: litigation, suitability, Deutsche Bank, Complexity Risk, Contingent Convertible Bond, ILS, insurance-linked securities, CoCo

Len Santoro, Fixed Income Expert, Joins Accelerant

Posted by Jack Duval

Oct 27, 2014 1:47:50 PM

Accelerant is excited to announce that Len Santoro wil be joining the firm as a consultant.  Len is the former CIO of Prudential's pension fund business.  He will be joining us to consult and provide expert testimony on fixed income, mutual funds, institutional asset management, and pension related areas.


A Q&A with Len is transcribed below:

Brendan Reese for Accelerant:  Describe your professional background?

Len Santoro:  The bulk of my investment management experience was at the Prudential.  I was hired directly out of Columbia Business School to manage the Pru-Bache mutual funds and a pension fund for the Western Conference of Teamsters.  A few years later I was part of a team that was formed to increase Prudential's presence in the pension fund management business. I eventually became the CIO of this unit which at its peak had assets under management in excess of $27 billion and a staff of 27 investment professionals. 

Reese: What kind of fixed income did you deal with?

Santoro: We were a global manager. Given that, about 75% was in the investment grade US market. The rest was in High Yield, Emerging Market and non-US government debt.

Reese:  How closely did you work with your pension clients in drafting their Investment Policy Statements?

Santoro: That really depended on the client.  Some were quite sophisticated and provided detailed investment objectives and guidelines.  I'm not talking just about sector and quality Limits but guidelines that included the duration range around specific market sectors and even coupon distribution in the mortgage sector.

Other clients needed more guidance.  In many cases proposed guidelines were included in the original RFP and were intended to link risk and reward.  Exploring the potential risks associated with large duration, sector and quality bets were key elements in establishing the guidelines and objectives of the portfolio.  

Reese:  How frequently did you see pensions change their IPS and what would be a typical impetus for that.  Also, what kind of issues would that raise from the asset management perspective?

Santoro: I recall a few instances when clients change both the portfolio objective and it's benchmark.  Both clients were very sophisticated.  In one case I remember getting a call at 11 o'clock in the morning and it was changed by the end of the day.  In another case, weeks of discussion preceded the change.

In another instance I recall an investment opportunity being presented that was not specifically permitted in our guidelines.  I reached out to the client and if I remember correctly within a month a change to the guidelines had been approved.

In most cases though, changes occurred due to some event that caused a violation of the guideline. I remember back in the 1990s when one of the automobile credit companies was surprisingly downgraded to junk.  Suddenly the market was being flooded with the paper because so many investment-grade portfolios had the same restriction of no junk.  We went to our clients looking for 6 month relief to let the selling pressures ease.  Again, it was a relatively easy process and our request was approved.

It is Important to remember that in many cases the guidelines evolve as situations change.  For example, assume the guidelines say that nosecurities shall be purchased with a non-investment grade rating. Does that mean that a bond purchased with a triple B rating and is later downgraded to below investment grade needs to be sold?  Clearly a conversation needs to be had between the client and the manager. Same type of example applies to maximum positions in individual securities or sectors.  I recall in some situations where a maximum sector position at purchase was set at 25% but in no case would exceed 30% as a result of changes in market value.  In this case both the client and the manager knew exactly how the portfolio should be positioned and what actions would be taken.

Reese: Tell me about the world of Taft Hartley asset management? What is it and how does it work? How is it different?

Santoro: A Taft Hartley pension plan involves a group of employers and one Union.  In my experience the plan is run by a Board consisting of an equal number of employer and union representatives. 

The pension is the result of a collective bargaining agreement. In managing assets there is absolutely no difference between a Taft Hartley and a single employer sponsored plan. The objective, guidelines, and benchmarks are all very similar.

The biggest difference can be with client service and reporting if the manager is required to meet with the entire board. In some cases, however, the plan uses an Investment Advisor that fills a role that the chief pension officer would have at a single employer sponsored plan.  In that case there is absolutely no difference (between their roles).

Reese: Throughout your long career watching the fixed income markets, what month or time period comes to mind as particularly interesting and exciting?

Santoro: I think the Paul Volker era was one of the most interesting periods.  The vice he put on the money supply to break the back of very high inflation was unprecedented and controversial.  Heck even in 1981 there was still doubt that he would be successful.  It was in that year the U.S. Treasury needed to put a 14% coupon on a 30 year bond!  His success has been well documented.

October 1987 was another interesting period. Those of us long enough in the tooth recall the stock market plunge, but little noticed the volatility in the bond market.  The long bond which normally traded with a bid/ask spread of a "32nd" ( a "32nd" amounting to $312.50 on a million dollar bond) suddenly traded at 2 or 3 point spreads ( a point being $10,000 on a million dollar bond).  This presented difficult problems for us since we had clients looking to add in excess of a billion US dollars to their bond portfolio.

The demise of Drexel was interesting in that it put counter-party risk back on the front burner which I am sure was was nothing compared to the chaos of Bear, Lehman and the 2008 crisis.


Reese:  What are some interesting developments you've seen in the bond market recently?

Santoro: These bank "CoCo" bonds are pretty interesting.  The CoCo stands for contingent convertible and are being issued as a safety net for the banks to maintain minimum capital levels under the Basel agreement. They are either converted into stock or written down entirely if the banks capital level reaches a certain trigger point.

The bond can never be converted to stock at the option of the bond holder.  In some cases if the trigger, defined  in each deal as somewhere between a 4% and 8% capital ratio, is breached the issuer can convert the bonds to stock or in some cases write down the value of the bond entirely.  

Some of the early research indicated that the market for these bonds was the retail investor.  That is clearly not appropriate.  The securities and the risk associated with them are way too complicated for a naïve investor.  In fact I believe the UK has banned sales to the individual market.  In addition I saw a recent HSBC deal that establish minimum lots of $200,000 which in effect minimizes retail participation.

Reese: What are some of your other interests?

Santoro: I love the markets, Italian cooking and my 2 Labrador retrievers. 




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Topics: fixed income experts, Contingent Convertible Bond, Taft-Hartley, Pension Management, Investment Policy Statement, Len Santoro

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