What makes CoCos a reliable source of returns during periods of market volatility?
Within the fixed income universe, Financial CoCos offer high coupons/yields compared to most fixed income products/sectors with an average duration which is relatively short and also generally better ratings than high yield corporate bonds. As a result, in periods of rates volatility for example, the elevated carry and low rates sensitivity can provide a cushion to absorb market shocks. The fundamental resilience of the EU banking sector makes these instruments particularly attractive since they are issued by large and very profitable banking groups with substantial capital buffers to protect from downside risks.
What role can CoCos play as part of a balanced portfolio?
CoCos are bonds issued by financial institutions predominantly across Europe. They provide exposure to a much-improved banking sector offering attractive income and capital appreciation potential with much lower volatility than banks’ equity. As a result, they can represent a valuable component of a balanced portfolio by providing a stable income (high coupons) and substantially lower risk than equity investments. CoCos can also provide diversification benefits to a traditional Investment Grade bond allocation or to a riskier HY corporate bond exposure in a balanced portfolio.
What potential risks do investors need to consider with CoCos?
The main risks for a CoCo investor are “trigger risk”, “coupon cancellation” and “extension risk”. Trigger risk refers to the potential conversion of CoCos into equity or full/partial write-down upon the breach of specific capital ratio thresholds. These capital triggers however are very remote and a bank with a capital ratio below the trigger level would be most likely already in resolution (default) with wider implication also for more senior debt securities. Coupon cancellation is a more realistic risk which requires in depth analysis of the specific bank fundamentals and capital buffers. Importantly however, banks have so far always paid CoCo coupons even throughout the Covid crisis and post Russia/Ukraine war whereas they had to cancel equity dividends in 2020 for example and other times in the past. Lastly, extension risk refers to the possibility of a CoCo to be left outstanding post first call date. This risk can be managed by carefully valuing the bonds to the most likely call date without assuming they will all be called at the first opportunity. These three risks can be well managed by a careful fundamental analysis and active approach in investing in this asset class.
The Fund Selector Asia Investment Forum Philippines was held on 12 May 2022 and was sponsored by Janus Henderson Investors, Jupiter Asset Management, Pimco and TT International.
Find out more about what was discussed and the strategies that were presented here: https://fundselectorasia.com/events/fsa-investment-philippines/
