Fixed income
18 Jun 2019

CoCos in various rate environments

Because of their unique characteristics, CoCos offer potential benefits in different rate environments.

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The Appeal of CoCos in Various Rate Environments

CoCos are contingent convertible bonds issued by banks and insurance companies. They were first issued after the global financial crisis and were designed in conjunction with regulators to help ensure that banks are sufficiently well capitalized to survive another severe shock to the global financial system.

CoCos act in many ways like ordinary callable bonds. They pay regular coupons to investors and can be called by their issurers on specified dates.  They offer comparatively high yields and low volatility versus some other asset classes.  The main difference between callable bonds and CoCos is that in the event an issuer’s financial health deteriorates below certain defined levels, CoCo coupon payments can be switched off. If the issuer’s financial health deteriorates even further, the CoCos to be converted into equity or written down, permanently or temporarily. For reasons we will describe below, we believe that in the best-capitalized European banks the likelihood of this happening is now very small, given the rise in equity ratios over the last decade.

A CoCos fund aims to provide a combination of income and capital growth. Because of their unique characteristics, CoCos offer potential benefits in different rate environments.

Some protection

CoCos are issued in perpetual form but, as noted above, they have an initial call at a specified date and then regular calls thereafter, usually every five years. During these call periods they pay semi-annual coupons. If a bank doesn’t call its CoCo, the coupon is reset at a set spread above the benchmark interest rate so, in an environment of rising interest rates, CoCos offer some protection.

The reset feature reduces the duration of the bond, and lowers the price sensitivity of CoCos to interest rate fluctuations. This provides an element of insulation from changes in rates.

It’s also worth noting that in rising and higher rate scenarios, banks are generally more profitable because they can generate higher returns from core activities such as lending. This should lead to improved balance sheets and more secure CoCos because of the improved financial status of the banking sector.

When rates go down

CoCos typically offer better risk-adjusted yields than other kinds of bonds, and this may particularly appeal to investors when rates are low. The average yield on CoCos is around 6 percent. CoCos from investment-grade issuers such as HSBC, UBS, Barclays and Credit Suisse have the potential to offer superior yields and lower volatility when compared to either bank senior debt or bank equity. The last row in the table below shows the yield per unit of risk for the Merian Financials Contingent Capital Fund versus other asset classes.

Another reason why CoCos generate attractive risk-adjusted yields is that they are relatively new financial products for which the net issuance has risen quite sharply over the past five years. Supply has outstripped demand, and this has led to CoCos currently looking cheap in our opinion.  Some lack of familiarity with the asset class as well as an expectation that they would be more volatile has also contributed to CoCos trading cheaply.

It’s worth noting that CoCos issuance will peak soon. This may be around the first half of 2020, making it less likely that the oversupply will remain.

We believe banks are significantly better capitalised than they were at the time of the global financial crisis. European banks have raised EU600bn in fresh equity since the crisis and de-risked their balance sheets, and they are more closely regulated. All the UK banks passed the Bank of England’s 2017 stress tests for the first time since the financial crisis.

Nevertheless, not all banks are equal and neither are all CoCos. It’s important to understand the risks of CoCos and weak banks and to focus on only the high-quality issuers. We view some issuers as uninvestable, for example Deutsche Bank, given its weak business model .

We believe that investing through a managed fund, such as the Merian Financials Contingent Capital Fund, rather than an exchanged traded fund (ETF), is the best way to gain exposure to CoCos. ETFs filter banks based on size of issuance rather than the strength in their balance sheet and also have a less diversified exposure to the asset class. Deutsche Bank is included in the CoCos index tracked by some ETFs.

We also believe that the unique attributes of cocos means they offer potential benefits for investors regardless of the interest rate environment.