What’s a coco? It’s really quite simple …
A “coco” or contingent convertible bond is a newer kind of security issued by banks and insurance companies. They were first issued after the 2008 global financial crisis, having been designed partly by regulators who wanted to ensure that banks are sufficiently well capitalised to survive another severe shock to the financial system.
They are attractive to banks because the issuance costs are as little as half that of equity. They are attractive to investors because they offer high relative yields along with low volatility. They are a fast-growing asset class, with around EU180bn issued by European banks so far, and a market expected to reach a maximum of around EU220bn – and potentially less than this – in the next few years. 
In the normal course of events, cocos function like ordinary “callable” bonds, they pay regular coupons to investors and can be called, or bought back, by their issuers on specified future dates. The key difference between cocos and ordinary callable bonds is that, in the event that an issuer’s financial health deteriorates below defined levels, regulators can switch off the coupon payments. Should an issuer’s financial health deteriorate even further, regulators would require the cocos to be converted into equity or written down, either permanently or temporarily.
For the vast majority of issuers, we believe that the risk of coupons being turned off or the coco being converted to equity, is extremely small. Why? Because since the financial crisis, driven by a significantly more rigorous regulatory environment, European banks are stronger and safer – they have raised around EU600bn in fresh equity since the crisis.
The results of the 2017 Bank of England stress tests (considered among the most stringent of any major bank regulator), showed that, even in the case of a severe economic downturn, with banks sustaining losses five times worse than in the global financial crisis, Core Equity Tier 1 ratios for all the UK’s largest lenders would remain above the coco equity conversion trigger level.
Attractive, Risk-Adjusted Yields
Given this relatively secure position, we believe cocos offer investors very attractive risk-adjusted yield in excess of that of European bank equities or senior debt. For example, the Merian Financials Contingent Capital Fund yields around 7.7% vs 8.4% for European bank equity (Euro Stoxx banks index), and the Merian fund’s volatility is 4.4% vs 21% for bank equity. The fund therefore is offering over 4-times the risk-adjusted yield of bank equity.
The biggest coco issuers are some of the largest names in banking: HSBC, UBS, Credit Suisse, Barclays, BNP Paribas, Banco Santander and Unicredit. The average credit rating for issuers is single A, although the coco issues are on average rated BB given where they sit in the capital structure. Nevertheless, not all cocos are created equal, and it’s important to be selective and choose the best cocos from the best issuers.
There are several additional important characteristics of contingent capital bonds. They have a relatively low correlation with other risk assets, including US high-yield corporate debt, and a slightly negative correlation with US Treasuries, meaning that they can provide useful diversification to portfolios. Cocos also offer a level of protection from rising interest rates because coupons offer periodic (usually five-year) resets at a spread above benchmark interest rates, meaning a rising coupon reset in periods of rising interest rates. Cocos are also one of the most liquid parts of the credit market due to the fact they do not sit in any fixed-income index and hence are traded much more actively.
We believe that cocos have been somewhat misunderstood and as a result, underpriced, for reasons that include their newness as an asset class, the large amount of issuance and their hybrid characteristics as a bond that can convert to equity. This may have led some investors to be unsure about where to place cocos in their portfolio.
This situation won’t last forever however. We estimate that more than three-quarters of the issuance is done – rules limit the amount of contingent capital that a bank can issue as part of its capital structure. We believe the market will come to understand cocos better, and given the attractive relative returns of this asset class, investors will find a home for cocos. They will come to agree with our view that cocos offer a compelling opportunity for investors. After all, it’s really quite simple.
The HSBC example
HSBC’s capital ratio is around 14.5%. If its capital ratio were to fall below 7%, then HSBC’s coco issuance would be converted into equity. There is also an interim trigger level of 9.2% for HSBC (it is different for every bank), where coco coupons get turned off, but also dividends are stopped along with management bonuses. However, the regulator would have insisted on a capital recovery plan well before this 9.2% level was reached.
Typically bank capital ratios move 10-20bps a quarter, so a 530bp fall in HSBC’s capital ratio – equal to a loss of around $46bn– to where the coupons are switched off, would be a monumental event.
Banks are still highly leveraged institutions relative to a normal company, but they are unrecognisable from the leveraged beasts they were prior to the financial crisis.
 BofA Merrill Lynch Global Research. Banks – The Contingent Capital Primer 1/7/2018