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Do we need to worry about CoCo bonds?

Europe's banks have seen their stock hammered over the past few days. One term that keeps on cropping up as financial sector equities take their rollercoaster ride is CoCo bonds, with investors concern centering on the banks' ability to pay them off.

Contingent convertible—or "CoCo" bonds differ from regular convertible debt in that they only convert to equity once a specified event has occurred, such as a share price hitting a certain level. They saw a record number of issuances last year, as central bank bond buying program forced government bond yields to record lows, sparking a fresh hunt for yield. Last year, issuers around the world launched 160 CoCo bonds according to data compiled by Dealogic for CNBC -- up from 109 in 2014.

Financial traders at the Frankfurt Stock Exchange
Hannelore Foerster | Bloomberg | Getty Images
Financial traders at the Frankfurt Stock Exchange

CoCos can be converted into equity or written off entirely if the issuing bank's capital drops below a pre-agreed threshold. Banks use them to raise loss-absorbing regulatory capital because they are cheaper than issuing equity.

Much of the volatility seen in markets this week has been attributed to fears that European banks might struggle to meet their liabilities, with the spotlight on German lender Deutsche Bank and its ability to make coupon payments on its CoCo or additional tier 1 bonds.

With liquidity in these markets all but drying up and the cost of insuring the bonds using credit default swaps (CDS) shooting to levels not seen since 2011, spooked investors were reminded of the onset of the financial crisis.

But despite the volatility and liquidity concerns, some investors looking at the sector are seeing buying opportunities. Shares and bonds in Deutsche Bank soared on Wednesday following reports that the group may stage a buyback of senior debt.

"I think there is no liquidity in CoCos, it is very hard to find buyers. Yesterday is the first time I started looking at them, we are not buying them yet. I think if we buy, it will be something more senior to that. But I think a lot of the bonds are pricing in an imminent disaster and the liquidity isn't there right now, the earnings growth isn't there right now. But the capitalization is - it's not like where we were in 2008. So we are getting down to valuations of a crisis level – but that crisis isn't there," Patrick Armstrong, chief investment officer of Plurimi Investment, told CNBC.

CoCos are considered a "junior" form of debt, meaning it is not as secure as other bonds issued by organizations and it is of a lower priority in the case of a default. But returns on CoCo bonds from developed market issuers have largely trumped those on other forms of bank debt.

"The yields are now getting so high. Deutsche Bank isn't about to go bankrupt. It has a lot is issues facing it, the equity may suffer stagnating prices. I am not sure which part of the capital structure you want to play right now. But I think bonds are offering a lot," Armstrong said.

Manager of a number of credit strategies at GAM Anthony Smouha, said he was cautious, but agreed that yields were looking too attractive to ignore.

"We will avoid buying debt of banks that are in troubled zones or that have questionable business models. We prefer older legacy securities as banks reshape their balance sheets for debt that is losing its regulatory capital advantages," Smouha said.

"We are a bit more cautious on the new CoCos, choosing only the best franchises and limiting our exposure. Good analysis is required and dogmatism must be avoided. But for certain bonds the yields are currently very generous and the current price setback may be an attractive entrance point," he added.