Fixed income
26 Jun 2019 | By Lloyd Harris, Huw Davies

Be selective to avoid excessive risk with CoCos

Analysing contingent convertible bonds, or CoCos, isn’t so different from other credit analyses

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Analysing contingent capital bonds, or CoCos, really isn’t very different from any other credit analysis. If you invest in a weak bank or any other weak credit name you won’t get much return, regardless of the asset class. CoCos from the best capitalized banks offer attractive risk-adjusted yields. We don’t think investors need to take excessive risks to get these yields in the CoCos market but they need to be selective and careful with the names they choose.

We would argue that CoCos are not much more difficult to understand than any other normal callable bond – an instrument many fixed income investors would hold without giving the matter so much as a second thought.

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, the coupon payments can be switched off. Should an issuer’s financial health deteriorate further, its CoCos can be converted into equity or written down, either permanently or temporarily.

For the majority of issuers, we believe that the risk of coupons being turned off or the CoCos being converted to equity, is extremely small. This is 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.

There has been a significant, and in our view, under-appreciated change in the capital structure of western European Banks. Bank equity ratios are more than two times larger now than in 2007 and that is on significantly different risk weighting for bank assets.[1] Banks carry much less risk on their balance sheets.

There are dozens of issuers, the majority of which are “household name” European banks and financial services firms such as HSBC, UBS and Santander. We think that CoCos investors should focus on high-quality issuers, where the banks are well capitalised, well run and profitable.

That’s exactly what we do with the Merian Financials Contingent Capital Fund. We use a robust, structured and repeatable four-stage process to analyse CoCos investments. This process includes reviewing the balance sheets and income statements of issuers and forecasting whether the institution has sufficient reserves to comfortably pay coupons and whether they can maintain a healthy capital buffer to the coupon and equity trigger levels.

The fund’s holdings have an average issuance rating of BB. The fund yields 7.7%[2] and has higher yield per unit of risk than senior bank debt or bank equity.

An example of a name we currently don’t invest in is Deutsche Bank, because we consider its business model to be structurally weak. Similarly, we always considered Banco Popular Espanol to be too weak a bank to invest in, which subsequently proved to be true in June 2017, when the bank was resolved by the regulator, the Bank of Spain.

On the other hand, in February there was a lot of commentary concerning CoCos issued by Santander, Spain’s largest lender. Santander was said to have “infuriated” and “stunned” many bondholders when it decided not to call the bond. This may simply have reflected a delay in receiving regulatory approval for Santander to redeem. Whatever the reason, the bond was not called, which many commentators viewed as a very negative event for the market.

We view Santander’s CoCos to be of high quality, from a very well-run global bank.  Whether the issue had been called or not, the yield on Santander’s CoCos appeared very attractive to us.  The commentary surrounding the issue served to create some extremely attractive entry points for the CoCos, which we took advantage of. The negative event never transpired, and Santander’s CoCos have now recovered to be pricing redemption at the next call, meaning that holders of the issue like us have enjoyed meaningful capital appreciation over that time.

Our strategy is to identify the strongest, best-capitalised banks that issue CoCos, and to select the most attractive individual issues. It’s a rigorous investment process that is easy to understand and it’s really not very different than any credit analysis that we undertake.

[1] Source: Citi Research estimates

[2] USD-hedged yield, as at 31/5/2019

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