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It’s been a tough 10 years for banks. Forced by regulators to cut risk and strengthen balance sheets, bank returns have declined. Meanwhile, central bank quantitative easing programmes pushed down interest rates, putting pressure on loan margins, while weaker market volatility reduced profits for trading desks. On top of that, fines for misdeeds and provisions related to payment protection insurance (PPI) mis-selling have also been drags on profitability.
Recent earnings reports have highlighted a change in the air, however, and we believe headwinds are becoming tailwinds for financials.
Most of the hard work on balance sheets had been done; common equity Tier 1 capital ratios are around 14% for UK banks compared with around 4.5% a decade ago, according to the Bank of England (BOE). All UK banks passed the most recent BOE stress test. There is upward pressure on interest rates as central banks wind down quantitative easing and as low unemployment in the US and UK signals wage growth. This should steepen the yield curve and improve banks’ lending businesses.
Meanwhile, the return in market volatility is good for investment bank returns, and PPI redress is slated to end in August 2019.
What’s left are stronger and safer banks, regulated in a utility-like fashion, with lower returns than before the financial crisis. Banks are returning their focus to volumes, margins, revenues – and dividends and buybacks.
Contingent convertible bonds, or “CoCos,” offer a way for investors to participate in the improved business of post-financial crisis banking. CoCos are a newer kind of hybrid debt issued by banks and insurance companies.
They have the potential to offer yield in excess of European bank equities, but with lower volatility. The yield is around 6% on the Barclays Contingent Capital Western European Index. On a risk-adjusted basis, the yield is considerably higher than that of equities or senior debt.
CoCos are a fast-growing asset class, with the increase in issuance driven by regulatory change. The current market issuance is around €190bn and is expected to reach €250bn in the next two or three years. Credit Suisse, HSBC and Barclays are among the issuers.
They were created in the wake of the global financial crisis to increase the capacity of banks to bear losses beyond their equity buffers. Most CoCos convert to equity when the issuer is under extreme stress. They offer less protection to investors than senior debt and more than equity.
Regulators are keenly aware of the importance of the asset class. They have encouraged the issuance of the securities and modified rules in order to enhance the ability of banks to service their CoCo coupons.
The relative newness of the asset class and its hybrid debt structure means it may be overlooked and potentially undervalued by some investors. We believe that CoCos offer a compelling opportunity.