The first CoCos were poured at the prompting of bank regulators, so perhaps it’s apt that the regulator is now pouring cold water on them.
Contingent convertible bonds – known as CoCos – first emerged after the financial crisis as an innovative way to strengthen banks’ balance sheets without exposing shareholders to dilution, other bondholders to default, or taxpayers to bailouts.
They pay a coupon like other bonds, and like other convertibles can be turned into shares in the issuer. But rather than having this conversion triggered by the share price, it happens if the bank’s capital ratio falls below a given threshold.
This is naturally an undesirable outcome for CoCo holders, so investors have had to be lured in by high coupons.
‘In a low interest rate environment many investors might be tempted by CoCos offering high headline returns,’ observed Christopher Woolard, director of policy, risk and research at the Financial Conduct Authority (FCA).
‘However, they are complex and can be highly risky, and the FCA has used its new powers to ensure that CoCos are not inappropriately made available to the mass retail market while still allowing access for experienced investors.’
The watchdog has duly now imposed a one-year ban on selling CoCos directly to retail investors, although they are still afforded indirect exposure through funds. The FCA will publish a consultation paper on permanent rules for CoCo distribution next month.
The regulator acknowledged that ‘at present there is little experience of how CoCos operate in practice’, but tipped their issuance to continue to grow. Analysts at Hermes have come to the same conclusion, suggesting the market could swell from around £60 billion today to £200 billion as ‘a theoretical boundary of its potential size’ if European banks hold 1.5% of their risk-weighted assets in CoCo form.
I should CoCo
The supply side of the market is driven by the regulatory imperative to reinforce capital ratios, as well as the fact that CoCos coupons are tax deductible for their issuers.
But what about the demand side? In part the attraction is simply, as the FCA supposed, the returns. In January Bank of America Merrill Lynch released the first dedicated CoCo indices: the mainstream index generated over 6% in the first half of the year, and the high-yield one more than 7%. This compares with less than 4% from Euro Financial index and below 5% from the Euro High Yield index.
Beyond this past performance, GAM’s Citywire AA-rated credit star Anthony Smouha highlights their appeal for when central banks hike rates. ‘They are very interest-rate friendly instruments in many ways,’ he argued.
‘They are structured in such a way that your dependence on the level of interest rates is lower because after a certain time they are re-fixed on a floating note basis.’
Olaf Struckmeier, portfolio manager at Union Investment, agrees that CoCos’ higher coupons provide a buffer against rate rises.
Should I stay or should I CoCo?
Of course, the trade-off for these advantages is the significant risk inherent in CoCos. First, they are much more volatile than other bonds. ‘You can’t compare the volatility of CoCos with senior secured bonds,’ said Struckmeier. ‘You have to compare it with equities.’
A related issue concerns how investors should conceptualise CoCos. ‘Analysis of a CoCo is more in the equity style than the standard fixed income style,’ explained Struckmeier. ‘We are trying to evaluate the ability of the bank to generate profits.’
This is because issuers can in some cases cancel coupons if their financial situation deteriorates, so it is not sufficient to check only that the bank can meet its interest payments and eventually repay the principal.
Fraser Lundie, an A-rated manager at Hermes, recalls the example of Groupama – whose bonds dropped by 18% on the day it cancelled coupon payments – as an indication of the potential for losses.
Bryn Jones, head of fixed income research at Rathbones, is cautious on CoCos as a result. ‘We believe CoCos should be priced as equity rather than bonds: coupons are discretionary, and investors bear significant write-downs or conversion risks. We believe bondholders are not adequately compensated for the risk taken and the risk of an issuer skipping a coupon is underpriced.’
The situation becomes murkier when local regulators’ idiosyncrasies are considered too. Danish authorities forced Danske Bank to boost its capital ratio by 100 basis points, for instance, while Sweden has compelled its banks into similar action by rejecting their historically low mortgage default rates as a basis for calculating their capital requirements.
‘Assessing the risk from regulatory intervention is both very difficult and also a considerable danger. As we cannot price this risk effectively, we often struggle to make investments in this space,’ confirmed Jones.
‘That is not in the instruments’ documentation,’ Struckmeier remarked. ‘You simply have to have a specialist in the region who knows what the regulator is up to.’
All these general risks are well understood by buyers, though, so the real skill is in extracting a sufficient premium from issuers. ‘You must do your homework. You must go in with your eyes open and you must go with the quality institutions,’ Smouha urged.
Struckmeier feels that such scrutiny has also improved the quality of issuance. ‘For weaker banks, it is nearly impossible to tap the CoCo market now.’
He avoids institutions dependent on unreliable investment banking revenues or with high litigation risks. That rules out Deutsche Bank, for example. Instead Struckmeier favours Swiss groups, which have shed investing banking divisions and refocused on steady wealth management.
Jones has made an exception to his general CoCo scepticism for a firm closer to home: the Coventry Building Society. ‘We invested in the bond at issue for our Strategic Bond fund as the society has the highest capital ratio of the sector. With a core equity Tier 1 ratio of 24.6%, we believe the risk of conversion is very low. Coventry Building Society is actually one of our preferred credits in financials.’