CoCos have much to offer investors, not least the combination of attractive risk-adjusted yields from investment-grade issuers, diversification properties and high liquidity.
We believe these attributes of CoCos (contingent convertible bonds) are enhanced further as those issuers, mostly banks but also insurance companies, slowly and steadily improve their financial performance.
It’s been a long haul back from the Global Financial Crisis, and since then banks have radically shrunk their balance sheets and renewed their focus on core deposits and lending. Financial results have improved, shares are moving in the right direction and profitability stands to benefit further from a steepening of the yield curve and the end of PPI complaints in the UK (£36bn paid out through June).
Banks have, in many cases, become more like utility businesses, well-regulated and providing necessary but somewhat unexciting services, with much steadier revenues. Their capital strength has increased dramatically, and that means CoCo investors are in an even safer place.
CoCos have performed well this year through September with the benchmark, the Bloomberg Barclays Contingent Capital Western Europe index (USD hedged) up 14.7%. The USD- hedged yield on the benchmark is 4.8%.
More importantly, the yield, when adjusted for volatility, far exceeds that on offer from bank equity or senior bank debt. From a valuation perspective and on a risk-adjusted basis, we believe the CoCos sector is one of the cheapest compared to other parts of the bank capital structure and other forms of credit.
Cheaper Than They Ought to Be?
A recent example of the yield premium of CoCos versus European corporates came when the telecoms company Orange (Baa1/BBB+/BBB+) launched a €750mn issue with a coupon of 0%, and maturity date of 4 September 2026. The deal was priced at a yield of -0.03%. A few days later, Rabobank came to the market with a CoCo with the first call on 29 December 2026 and a coupon of 3.25% – a spread to the Orange deal of 328bps.
CoCos also have useful diversification properties as part of a well-balanced portfolio with a low correlation to asset classes including high-yield bonds, equities and Treasury notes. They also trade in a large and liquid market.
Supply Is Limited
Supply of CoCos is set to ease as early as next year and this may impact pricing. Western European banks are limited by regulators in the amount of CoCos they can issue as part of their capital structure, and we estimate that the market will peak at around $220bn, with around $200bn already in issuance, or about 90% of the total.
We expect that as the net new issuance eases, the yield premium of CoCos will be reduced, and the existing issues will be well supported.
Adding limited supply to the list of attributes–attractive risk-adjusted yields from investment-grade issuers, healthier banks, low correlations, solid performance and a large liquid market–means we think the rationale for owning CoCos is getting better all the time.
 Source: Financial Conduct Authority, as at 28/8/2019. Figure includes January 2011-June 2019.
 Source: MGI/Bloomberg as at 30/9/2019
 Source: Bloomberg as at 2/9/2019
 Source: MGI estimates as at 15/11/2019