Managing a portfolio of CoCos requires specialist knowledge of the asset class as well as a deep understanding of financial equity and credit markets.
CoCos, or contingent convertible bonds, are 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 capitalised to survive another severe shock to the global financial system.
The biggest CoCo issuers are some of the largest names in banking: HSBC, UBS, Credit Suisse, Barclays, BNP Paribas, Banco Santander and Unicredit. Nevertheless, because the asset class is relatively new, it can sometimes be misunderstood by investors.
The Merian Financials Contingent Capital Fund aims to be selective, choosing the highest quality and best value CoCos from issuers with the strongest balance sheets and capital generation characteristics.
To do this, the fund uses a robust, structured and repeatable four-stage process overseen by experienced portfolio managers. The first stage is an in-depth credit analysis of the issuer, including an equity forecast and credit modelling.
Stage One looks at the capital of a bank as well as asset quality, management, earnings, liquidity and the macro environment. This process excludes around 15% of our identified universe.
Stage Two is a review of distributable reserves to determine whether an issuer has sufficient reserves to pay future coupons. Distributable reserves are an accounting item and if they are not present will preclude banks from paying dividends and coupons on CoCos. Deutsche Bank and Commerzbank and are excluded at this stage. In all, a further 10% of our analysed banks are excluded by Stage Two.
Stage Three is a forecast of an issuer’s future equity ratios and whether they will maintain a healthy capital buffer between current equity ratios and the coupon and equity trigger levels for CoCos. Our analysis excluded Banco Popular prior to it being resolved by the Spanish regulator. This third stage takes out another 10% of analysed banks.
Once we have excluded all the banks we deem to be too weak to invest in, the last stage of the process picks the best relative value on the CoCo curve.
The fund’s portfolio managers are Lloyd Harris, who is a member of the Merian Global Investors (MGI) fixed income team and lead manager of the MGI Corporate Bond Fund, and Rob James, a member of the MGI UK equity team and financials specialist. Their combined expertise in debt and equity analysis provides special insight into this unique hybrid asset class. They also benefit from their extensive experience analysing banks and insurance companies.
Investors can buy CoCo ETFs to gain exposure to the this market, however, ETFs filter banks purely on size of issuance rather than the strength in their balance sheet and also have a less diversified exposure to the asset class. We believe that only investing in strong banks, regardless of size, is the way to access this market’s true value. Deutsche Bank, which we noted above is excluded from investment based on our analysis, is included in the CoCos index tracked by some ETFs.
We believe that not all CoCos are equal. That’s why we choose our CoCos carefully, and we believe that you should too.