“A CoCo is a hybrid between equities and bonds,” Sullivan, investment director for fixed income at Old Mutual Global Investors, told FSA.
It is a debt instrument which is convertible into common shares when triggered, either automatically – by the issuer’s stock price or capital measures – or at banking supervisors’ discretion.
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.
A bank tool
Contingent convertibles are a relatively new product. The first CoCo was issued by Lloyds Bank in 2009. They became a common tool for funding banks’ additional tier 1 capital, required by regulators after the global financial crisis of 2008.
European and UK regulators stipulate that banks raise at least 1.5% of capital via CoCos. Since 2014, when the issuance took off, banks have issued close to €150bn ($163bn) in these products, according to Sullivan.
CoCos appear to be attractive investments in a low interest rate environment. Regulators are promoting CoCos as a safety buffer for banks in distress. Banks like issuing them since the coupon paid on the debt is tax-deductible. And investors like the yields in the 6%-7% range.
The attractive yield, however, comes with risk. While CoCos are backed by the credit of the issuer – usually a major A-rated financial institution – the securities themselves carry provisions which make them equivalent to junior debt, rated BB+, explained Sullivan.
Investors need to take into account two risks when investing in CoCos: that of conversion, which, if happens, turns investors into owners of the asset, and the possibility of banks skipping a coupon payment. The CoCo structure allows the issuer (the bank) to miss a coupon payment without triggering default.
With most European banks having significantly improved their capital ratios since 2008, the risk of conversion is generally very low, as evidenced by recent stress tests in the UK and the Eurozone, according to Sullivan.
A couple European banks, Deutsche Bank and UniCredit, have given investors a reason to worry about banks paying coupon on their CoCos in early 2017. Sullivan explained that the future cost of a skipped coupon payment would be larger than that of raising new capital, thereby providing a very strong incentive for banks to raise new capital in other ways.
Both banks have announced euro rights issues in March to boost their common equity tier 1 capital ratios, thereby avoiding a skipped payment on their CoCos.
In addition to high yields, investors in CoCos benefit from their low volatility and low correlation with other assets.
“Volatility of CoCos is a fifth of that of bank equity,” said Sullivan.
CoCos are perpetual securities, callable by the bank, with a floating coupon that resets every five years, in most cases. This reduces their sensitivity to interest rates and correlation with bonds.
“They are negatively correlated to treasuries,” said Sullivan. “CoCos have a 6% correlation to credit and their correlation to equities is about 65%”.
OMGI is planning to launch a CoCo fund in August 2017. The Dublin-domiciled Ucits fund will be registered for sale in Singapore, said Sullivan.
