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CoCos: A bet on banks’ financial health

Contingent convertible (coco) bonds carry conversion risk but promise high yield with low volatility and diversification, according to Lloyd Harris, London-based fixed income fund manager at Old Mutual Global Investors.
Lloyd Harris, Old Mutual Global Investors

“[Cocos] are negatively correlated to US treasuries and for UK gilts and corporate bonds, it is close to zero,” he told FSA during a recent visit to Hong Kong.

He added that cocos are more correlated to equities, exhibiting their nature as “true hybrid” securities. The correlation of cocos to the MSCI World is 0.57 and 0.39 with the S&P 500.

Cocos are debt instruments issued mostly by banks and some insurers that are convertible into common shares when triggered, either automatically – by the issuer’s stock price or capital measures – or at a banking supervisor’s discretion.

They should not be confused with convertible bonds, in which the holder has the option to convert the bond into equity, Harris noted.

The triggered conversion into equity is designed to recapitalise the bank at times of financial distress, in order to avoid the necessity of a taxpayer-funded bail-out. Cocos were introduced by banking regulators in the wake of the global financial crisis of 2008. For a detailed report about cocos, click here.

Harris argues that cocos are attractive to investors given the promise of relatively high yield and low volatility during a time of low interest rates and increasing volatility.

He added that the asset class is also undervalued because the conversion feature makes them more complicated to analyse than equities and standard bonds.


Source: Old Mutual Global Investors


Risky bet?

One big risk that cocos carry is the conversion to equity, which would amount to a haircut on their value, similar to that applied to other types of debt in case of bankruptcy resolution.

Indeed, a Bloomberg report referred to cocos as “a high yield investment with a hand grenade attached” and cited the 2017 case of Spain’s Banco Popular Espanol, “when regulators wiped out investors in €1.25bn ($1.4bn) of coco bonds”.

Harris believes that the risk of conversion remains benign.

“In reality, we think that getting into conversion is extremely remote,” he said, adding that banks are better capitalised now compared to 2007.

Investment process

Harris co-manages with Rob James the Old Mutual Financial Contingent Capital Fund, which is a pure coco fund that was launched in August last year.

This is not the first time that the firm has invested in cocos, Harris noted, adding that the firm’s other fixed income funds have some allocations to the asset class.

The fund’s investment universe include cocos issued predominantly in developed markets. The majority of its assets are invested in the UK and in Europe, according to its fund factsheet.

Source: Old Mutual Global Investors

When investing in cocos, Harris likes high quality banks, which are those that have good credit health.

“The big part of the investment process is looking at their credit fundamentals and monitoring their capital health.” He also looks at whether the loans the bank gives are also of good quality, he added.

Assets of the fund have increased to around $250m from $100m when the fund was launched. It is available to professional investors in Hong Kong and accredited investors in Singapore.

In Asia, only a few coco funds are offered to investors. They include Credit Suisse Asset Management’s 1 (Lux) Contingent Capital Euro Fund, which has $57.75m in assets, and Bluebay’s Financial Capital Bond, which has $593.1m in assets, according to FE data. Both funds were launched in 2015.


The Old Mutual Financial Contingent Capital Fund vs the ICE BofAML Contingent Capital Index since the fund’s inception

Source: FE. In US dollars. The fund is available to professional investors in Hong Kong and accredited investors in Singapore. The fund’s benchmark index, the Bloomberg Barclays Contingent Capital Western Europe USD Hedged Index, is not available in the FE database.

Part of the Mark Allen Group.