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In February, Spain’s largest lender, Santander was said to have “infuriated” and “stunned” many of its bondholders when it decided not to call (essentially, buy back) one of its contingent convertible bonds, or “cocos,” when it had been expected to do so. In practice, this may simply have reflected a delay in receiving regulatory approval for Santander to redeem.
Just a couple of months later, with another of its euro-denominated cocos approaching a call date, the bank announced it would be redeeming that instrument, in the process generating further animated commentary and headlines.
To my mind, the question for coco investors is to ask why the market has reached a point of quasi-obsession with this so-called “extension risk,” in other words, the likelihood of an issuer declining to buy back the bonds, and instead allowing the instruments’ coupons to reset.
The recent coverage of Santander’s cocos is an excellent example of why, in my view, such narrative only serves to create some extremely attractive entry points. Here’s why…
As “perpetual” instruments which, if never called, will simply continue paying their coupons at a given level until they are “reset,” investors can think about cocos in terms of either the yield to call, or the yield to maturity.
Within the Merian Financials Contingent Capital Fund, we have previously used price weakness within Santander’s cocos – resulting from the market’s obsessive concerns over “extension risk” – to buy what we consider to be high-quality instruments, from a very well-run global bank, but at highly attractive valuation.
To put this in perspective, at the turn of the year, one of these issues was trading at approximately 89 cents, giving a yield of around 11.5% on a yield-to-call basis, or 10.3% on a yield-to-maturity basis. Whether the issue had been called or not, the downside risk appeared, to us, to be minimal. As a matter of record, the issue is now trading very near to par value, meaning that holders of the issue have enjoyed meaningful capital appreciation, too.
Given the reality described above, I view with more than a little bemusement the often hyperbolic and speculative nature of the recent commentary around Santander’s cocos. For our part, we will continue to focus on the important and definable tasks of identifying the strongest issuers of cocos, selecting the most attractive individual issues, and seeking promising entry points. If there is one obvious advantage to the recent news flow and uncertainty, it is that it has certainly helped us to do the latter.