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Fixed income
22 Oct 2019 | By Huw Davies

CoCos and the Search for Yield

CoCos may have an important role to play as interest rates fall across the yield curve and increased life expectancy in developed markets fuels demand for investment income.

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CoCos may have an increasing role to play as investors search for better yields in a period of low interest rates, says Huw Davies, investment director for fixed income at Merian Global Investors.

The ever desperate search for yield as global interest rates fall across the curve and developed economy longevity appears to inexorably extend, has been a theme for bond markets for a number of years and one that is not going away any time soon.

An examination of longevity in developed economies shows that this trend is likely to extend over coming decades:  

Life Expectancy at Birth, England and Wales, 1841 to 2010-2012

Source:  UK Office for National Statistics, 2015 https://www.ons.gov.uk/peoplepopulationandcommunity/birthsdeathsandmarriages/lifeexpectancies/bulletins/eng

To fund this extending lifespan people will need to save an ever greater amount of their income and when retired have assets that can pay an income on those savings. The need for interest-paying securities will continue to grow, especially if core developed rates remain close to zero or move further into negative territory.

However the key question when accessing yield is not just the headline income yield available but how much risk do investors have to experience to access that yield and also how much liquidity can they retain when selling out of lower yielding assets to buy into higher yield.

The reality of financial markets is that if an investor is willing to give up a lot of liquidity and also endure a high level of price volatility then higher yields are always available. So it is a balance between these three variables of yield, risk and liquidity.

The last few years have seen huge growth in the direct lending market as banks moved away from certain types of lending driven by regulatory change. Investors can access 8% yields in this market, but are moving a significant way down the credit curve and also have to experience significantly reduced liquidity relative to traditional fixed income investing.

However when traditionally traded corporate debt has seen headline yields move so much lower in recent years, then it is understandable that investors have moved in this direction even if with a degree of trepidation.

A recent example of how far European corporate debt has moved was recently brought to the market. The telecommunications company Orange (Baa1/BBB+/BBB+) launched a €750mln issue with a coupon of 0% and a maturity date of 4 September, 2026. The deal was priced at a yield of -0.03% – minus 3bps for a BBB+ rated telecommunications business for 7yrs! No wonder investors are searching elsewhere for yield.

However, we would propose that it is still possible to access yield, without compromising liquidity and also investing in issuers who have a strong underlying credit quality. A couple of days after the Orange issue was launched, Rabobank came to the market with a contingent capital deal. The first call on this issue was 29 December, 2026, a few months longer than the Orange deal, but with a coupon of 3.25% and a spread to the Orange deal of +328bps.

Now the comparison is with a callable bond versus a final-maturity bond, though both are rated BBB+. However, Rabobank’s issuer rating is Aa3/A+/AA-, and in its 150yr history it has never posted a loss. To me a spread of 328bps between these two issuers doesn’t make any sense at all.

Contingent capital in our opinion continues to offer very attractive yields in comparison to regular corporate debt as well as other types of financial banking exposure (either equity or senior debt). The Merian Financials Contingent Capital Fund invests in a diversified range of Western European financial credits, has a relatively low price volatility of around 4.4%, and operates in a market where the liquidity is significantly better than in large parts of the investment grade corporate bond market. It also pays a distribution yield of 5.95% in euros, which is paid out to investors monthly if they want the income.

For a market starved of yield, this looks to me to be a very attractive flow of income.

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