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Bluebay: Mispricing a boost for cocos

Contingent convertible (coco) debt of European banks is mispriced relative to other bank debt and this presents an arbitrage opportunity, argues Marc Stacey, portfolio manager at Bluebay Asset Management.
Spoon over heap of cocoa powder

Cocos were introduced by banking regulators in the wake of the global financial crisis of 2008. Their purpose was to make it easier for banks to re-capitalise in case of impending failure. The provision was in addition to the higher level of equity capital that regulators now require banks to hold on their books.

Previously, FSA reported in more detail about cocos.

Ranking below senior and subordinated debt, cocos carry a risk of a missed coupon, which banks can do without triggering a default, and the risk of conversion to equity. The conversion, would, in essence, amount to a “haircut” on their value, similar to that applied to other types of debt in case of bankruptcy resolution.

Due to this extra risk, the cocos of a top French bank, for example, offer a yield around 250 basis points higher than the bank’s senior debt and around 200 basis points higher than its subordinated debt, according to Stacey.

However, in Stacey’s view the difference in the risk of a haircut is not that big between cocos (also known as alternative tier 1 capital) and subordinated debt (lower tier 2), and the high spread presents an arbitrage opportunity.

Mispriced cocos

One of the reasons for the mispricing is that cocos are not eligible for inclusion in investment grade or high yield bond indices. As such, demand for them is lower than for other types of bank debt, which depresses their prices.

Although the spread has indeed been shrinking, the mispricing is still present, according to Stacey, and a further closing of the spread is likely to boost the returns of this type of securities in 2018 as it did in 2017.

The ICE Bank of America Merrill Lynch Contingent Capital Index increased 14.5% this year (until 31 October), which Stacey attributes in part to the declining risk premium on cocos.

Marc Stacey, portfolio manager, Bluebay Asset Management

Stacey and Justin Jewell have been co-managers of the BlueBay Financial Capital Bond Fund since its inception in January 2015. While the fund is allowed to invest in all types of bank debt globally, it is heavily concentrated in cocos of European banks, where Stacey sees the biggest opportunity.

With high coupons, cocos also offer an attractive carry yield around 6%. This has enabled the Bluebay fund to deliver a 24.3% one-year return as of 30 November, beating the ICE coco index and ranking among best-performing fixed-income funds.

The fund uses both top-down macroeconomic analysis and the bottom-up approach to selecting securities. It invests in cocos of only the top “national champion” banks across Europe, in order to minimise issuer risk, he said.

Stacey attributed the fund’s performance chiefly to issuer selection, but he added that his currency and interest rate exposures have had positive effects as well.

Banks grow safer

Thanks to regulations implemented after the global financial crisis of 2008, European and American banks have become far less leveraged, and less risky, Stacey told FSA.

“They are less reliant on cues from their proprietary trading desks,” and have more emphasis on the advisory and asset management business, which are not as cyclical, he said.

“There has been a growing realisation among the investors that banks are improving, but they are still cheap from the valuation perspective,” Stacey said. “Investors who got burned in the financial crisis and have shied away from banks have seen the fundamentals improve, the volatility come down and are getting more engaged.”

Although certain European banks, such as Spain’s Banco Popular, or Italy’s Monte dei Paschi, Veneto and Popolare di Vicenza, had run into trouble, the new regulatory regime allowed for their resolution in 2017 without adverse effects for the sector. Bank bonds rallied as the idiosyncratic risk was removed.

As a result, in 2017 there was a fair amount of capital appreciation in the financial sector, Stacey noted.

Looking at 2018, Stacey noted that the market was currently underpricing the risk of a sharp rise of interest rates and volatility.

“That would be bad for equities,” he said, “and banks would not be immune.” He’s been keeping the fund’s rate duration low in order to hedge some of this risk.

Performance of the Bluebay Financial Capital Bond Fund since inception, vs its benchmark and category average.

Part of Mark Allen.