CoCo bonds (contingent convertible bonds) are a specific type of subordinated bank debt introduced after the 2008 financial crisis as part of the Basel III regulatory framework. Their key feature is conditional loss absorption: When pre-defined trigger events occur — typically if a bank’s capital ratio falls below a certain threshold — the bond is automatically converted into equity or written down partially or entirely. CoCo bonds therefore act as a buffer that absorbs losses before other creditors or taxpayers are affected. They are often referred to as AT1 instruments (Additional Tier 1 capital), as banks use them to strengthen their core capital under Basel III.

Most CoCo bonds have no fixed maturity (they are perpetual) and can only be called by the issuer after a minimum holding period. They are hybrid in nature: On the one hand, they behave like bonds with fixed coupons; on the other hand, their conversion or write-down mechanism makes them economically similar to equity. Importantly, coupon payments are discretionary. A bank may suspend payments without entering default. As a result, investors assume materially higher risk compared to traditional bank bonds and receive higher spreads in return. CoCo bonds typically offer high single-digit yields, compensating for both credit risk and the potential for conversion or write-down. This combination — attractive income potential alongside the possibility of rapid capital losses in times of stress — forms the core of the CoCo bond structure.

The issuance of CoCo bonds is closely linked to regulatory requirements. Under Basel III, banks may use Additional Tier 1 instruments such as CoCos to cover part of their core capital, typically around 1.5 percent of risk-weighted assets. The objective of regulators is clear: Banks should be equipped with stronger capital buffers so that losses are borne by private investors in times of stress, rather than by the public sector. To qualify as AT1 capital, CoCo bonds must meet specific criteria, including a clearly defined conversion or write-down mechanism, perpetual structure and the possibility to suspend coupons. If these conditions are satisfied, CoCos can be recognised as part of a bank’s core capital.

However, the design and treatment of CoCo bonds can differ materially between jurisdictions. National supervisory authorities apply different rules, which can lead to divergent outcomes in stress situations. The Credit Suisse case highlighted this in 2023: The Swiss regulator FINMA used emergency powers to write down the bank’s CoCo bonds to zero while equity investors were not fully wiped out – a departure from the usual creditor hierarchy. European supervisors reacted quickly and clarified that, within their remit, common equity would absorb losses first before AT1 instruments are written down. This episode underlined that CoCo bonds can be treated differently under Swiss regulation compared with the EU.

The detailed terms of CoCo instruments also vary. Some CoCos convert into shares, others are written down permanently or temporarily. For investors, this creates a high level of complexity: Each security comes with its own set of clauses, and the legal environment helps determine how loss absorption will work in practice.

In addition to the trigger mechanics themselves, the capital position of many institutions is now significantly stronger than a decade ago. Since 2014, the average CET1 ratio of European banks has risen from around 11.5 percent to close to 18 percent; typical AT1 triggers are set at about 5.125 or 7 percent, depending on the issuer. This means that the buffer above the trigger level has increased from just over 5 percentage points to more than 12 percentage points in many cases. At the same time, non-performing loans (NPLs) in Europe have fallen from over 6 percent in 2014 to below 2 percent and have remained under this threshold since 2021. Profitability has also improved: Return on equity is currently around 11 to 12 percent, supported by higher net interest margins, which have risen from roughly 120 basis points to more than 200 basis points since 2022/2023.

In recent stress tests, European regulators applied very severe scenarios, including a 6.3 percent decline in EU GDP, a 5.8 percentage point increase in unemployment, inflation peaking at 10.7 percent and sharp corrections in property markets (commercial real estate down 30 percent, residential down 16 percent). Even under these assumptions, the average CET1 ratio fell by around 370 basis points but remained well above typical AT1 trigger levels. This suggests that, based on current data, the probability of a trigger event is comparatively low and that CoCo coupons are likely to continue to be serviced in most scenarios.

Given their complex structure and distinctive risk-return profile, CoCo bonds are not suitable for all investors. In many cases, these instruments are accessible only to professional or institutional investors. Private clients often cannot invest directly in CoCos, partly due to regulatory restrictions and partly because investor-protection considerations require a high level of technical understanding. Without in-depth knowledge of the banking sector and the mechanisms behind CoCo instruments, it is difficult to assess the risks appropriately — such as the probability of a trigger event or whether the higher coupon sufficiently compensates for potential losses.

The risks associated with CoCo bonds are substantial. In an extreme scenario, investors can suffer a complete loss of capital, as demonstrated by the Credit Suisse case. In addition, coupon payments may be suspended if a bank’s capital position falls below required levels, without giving investors any recourse. CoCos are also markedly more volatile than traditional bonds, as even a small loss of market confidence in an issuer can lead to sharp price declines. Their subordinated status means that CoCo holders rank just ahead of equity in the loss-absorption hierarchy, further increasing potential downside.

This combination of subordination, conversion or write-down risk and complex contractual terms makes CoCo bonds unsuitable for conservative investors. They are primarily appropriate for specialised, professionally oriented investors who understand these risks and have the expertise to evaluate them. Typically, asset managers, wealth managers and specialised credit funds invest in CoCos. For private clients, indirect exposure via dedicated funds may be possible, although minimum investment levels are often high.

Overall, CoCo bonds represent a niche segment suited only to a relatively small group of risk-tolerant, knowledgeable investors. They are neither broadly accessible nor broadly advisable for the general investing public.

Interestingly, the restricted investor base in the CoCo segment creates market inefficiencies that can also present attractive opportunities. Because certain investor groups — such as many private clients or risk-averse institutions — either cannot or prefer not to invest in CoCos, the market is not priced as efficiently as other major bond segments. Added to this is the high degree of structural complexity: Each CoCo bond can include different contractual features, and supervisory treatment varies across jurisdictions. Together, these factors lead to recurring mispricings in the CoCo market.

For specialised investors, this environment can open the door to meaningful excess-return potential. A common example is relative-value discrepancies between CoCo bonds issued by the same bank. It is not unusual for two instruments with similar risk characteristics to offer surprisingly different yields. Small differences in currency, contractual terms or liquidity can play a role. Investors who systematically identify the most attractively valued issues — and avoid those with weaker risk-return profiles — can generate a recurring yield advantage. In certain cases, excess returns of up to two percentage points per year have been observed.

These opportunities are far less common in established bond segments and exist precisely because CoCo bonds remain a specialised niche. In addition, CoCos typically offer high spreads relative to government or senior corporate bonds, providing above-average running yields. Even in late 2023, after the temporary dislocation triggered by the Credit Suisse event, average yields in the EUR AT1 segment remained close to nine percent — a level rarely found in other fixed income markets.

For risk-aware investors with the required access and expertise, CoCo bonds can therefore offer attractive return potential, provided the associated risks are understood and managed appropriately.

Capturing the opportunities in the CoCo market requires far more than a passive buy-and-hold approach. CoCo bonds are not instruments that investors can simply purchase and set aside. Their structures differ widely, market conditions can change quickly and regulatory developments must be monitored continuously. As a result, active management is essential in this asset class for several reasons.

• Targeted security selection plays a central role. Through detailed fundamental and relative-value analysis, an active manager can identify the most attractively valued instruments within a single issuer. As highlighted earlier, different CoCo tranches from the same bank can display meaningfully different yield levels despite similar risk characteristics. A focused relative-value approach seeks to consistently allocate to the most attractive issue while avoiding bonds with an unfavourable risk-return profile. Over time, this can generate a measurable performance advantage, with additional returns of up to two percentage points per year observed in some market phases.
• In addition, market dynamics in the CoCo segment often behave differently from traditional bond markets. In periods of financial-market stress, spreads on CoCos typically widen more sharply than in other fixed income segments. Prices can therefore fall disproportionately during uncertainty — which, for an active investor, may present an opportunity. When fundamentally sound banks experience market-driven spread widening, targeted purchases during such dislocations can benefit strongly from subsequent recoveries. The rapid rebound of the AT1 market after the March 2023 shock illustrates this behaviour. A passive investor, by contrast, tends to miss these opportunities.
• Active management also means maintaining a close view on regulatory and legal developments. Supervisory authorities can introduce new rules or intervene in stressed situations, as seen in Switzerland in 2023. An experienced manager considers issuer-specific contractual terms, evaluates jurisdictional differences and reduces exposures where legal frameworks might disadvantage CoCo holders in a stress scenario. Likewise, if a bank shows early signs of structural weakness, a disciplined manager will adjust exposures proactively to reduce risk.

Taken together, CoCo bonds require ongoing supervision, analytical depth and flexibility. Only an active, research-driven approach can harness the return potential of this market while keeping risks under control. For most investors, relying on specialised managers is therefore the more suitable route.

A robust diversification strategy is another essential component of successful CoCo investing. The CoCo market is dominated almost exclusively by large, systemically important banks, and many indices or passive products therefore carry significant concentration risks. In some market segments, individual issuers can account for up to ten percent of an index — a level of concentration that requires active management and careful oversight.

A well-constructed CoCo portfolio limits exposure to any single issuer and avoids accumulating several CoCo bonds from the same bank. Instead, diversification across a broad range of institutions helps reduce dependency on individual issuers. For example, a portfolio may define a maximum issuer weight — such as four percent — to ensure that even a severe stress event at one bank would have only a contained impact on overall performance.

Alongside issuer diversification, selecting the most attractive bond per issuer is equally important. Many banks have multiple CoCo tranches outstanding, each with different spreads, contractual terms or liquidity characteristics. Systematically choosing the most attractively valued issue — for instance, the bond with the highest spread after adjusting for currency and maturity — can meaningfully improve the portfolio’s return profile.

Because concentration risks are more pronounced in the CoCo universe than in many traditional bond markets, disciplined diversification is essential. A portfolio that spreads risk across issuers and focuses on the most compelling individual instruments can help smooth volatility and increase the likelihood of capturing the high coupons typical for this asset class, without being disproportionately affected by a single issuer event.

CoCo bonds are undoubtedly a double-edged sword. On the one hand, they offer attractive return potential through high coupons and benefit from market inefficiencies rarely found in other fixed income segments. For professional investors who understand the mechanics of this asset class — or who rely on an experienced active manager — CoCos can be a compelling addition to a portfolio, especially in environments where traditional bonds generate only modest yields. In practice, disciplined selection, active management and consistent diversification have frequently enabled investors to earn additional returns.

On the other hand, the risks are substantial: Coupon suspensions, pronounced drawdowns during periods of market stress and, in the worst case, a total loss of capital — as demonstrated by the Credit Suisse case in 2023. CoCo bonds are not suitable for all investors and require expertise as well as a clear tolerance for risk.

So, are CoCo bonds attractive despite the risks? The answer is nuanced. For the right investor profile, yes. Those who understand and can manage the specific risks may be well compensated. Specialised investors, supported by active strategies and broad diversification, can achieve attractive returns at a risk level they consider acceptable. For unspecialised or conservative investors, however, CoCos are not advisable due to the complexity and the heightened risk of losses.

Overall, CoCo bonds are high-yielding specialist instruments for experienced market participants. They are neither a risk-free opportunity nor a reckless gamble — provided one knows how to handle them. The initial question can therefore be answered clearly: CoCo bonds can make sense for professional investors with the necessary know-how and an active investment approach; for others, the risk-return profile of these hybrid instruments remains difficult to manage.