Some cocos are still risky, Merian says

Asset Class in Focus

The European banking sector has strengthened, but Merian Global Investors believes that not all contingent convertible (coco) bonds are attractive.

Cocos are debt instruments issued mostly by European and UK banks 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.

The triggered conversion into equity is designed to re-capitalise the bank at times of financial distress, in order to avoid the necessity of a taxpayer-funded bail-out. Cocos were introduced by the European and UK regulators in the wake of the global financial crisis of 2008.

Cocos started to become a major asset class in the middle of the European banking crisis in 2013. Their conversion-to-equity feature, which if triggered would amount to a haircut on their value, has some investors categorising the products as high risk.

Rob James, London-based portfolio manager at Merian, acknowledged one case of a coco that was converted into equity, citing the 2017 case of Spain’s Banco Popular, when investors lost around $1.4bn.

"Even though Deutsche Bank cocos yield 10%, if you don’t have enough capital, you might not be able to pay your coupons"

“During that time, Spanish banks, as well as Italian banks, had a lot of non-performing loans. When Banco Popular wrote its loans down, it was losing money and its capital level was going down.

“But at the same time, Basel III regulations were being phased in, and so the capital requirement was also going up,” he told FSA during a recent visit in Hong Kong.

However, he believes that the European banking system has strengthened and now the risk that cocos will convert to equity has been reduced.

He explained that a coco is converted when the equity capital ratio for a European bank falls below 5%, or 7% for US banks.

“But the capital levels of the banks now are way above that trigger point. [On the average], the equity capital ratios for banks now is at 13.5% today, which compares to just around 3-6% in 2013,” he said.

James added that the asset class is attractive. They yield at around 7%, which is high in a low yielding environment.

“Although their yield is high, they are issued by investment grade issuers, and their volatility is lower than that of senior bonds.”

Watching for weakness

James co-manages the firm’s pure coco fund – the Financial Contingent Capital Fund, which was launched in 2017. The fund is only offered to professional investors in Asia and in Europe.

While he believes that cocos have become less risky, he still steers away from weak banks.

“The entire process of the fund is identifying the weakest banks and not going anywhere near them.”

James likes strong balance sheets, high capital reserves and what he perceives as solid management.

“There are some banks that fail at [these criteria] and there is no price at which we will buy weak banks.”

For example, the fund has never held Deutsche Bank, which James believes has a little capital buffer.

“Even though Deutsche Bank cocos yield 10%, if you don’t have enough capital, you might not be able to pay your coupons.”

He added that Deutsche Bank also caused the coco market to wobble three years ago, especially after the bank faced a $14bn US fine over mis-selling mortgage securities in the US. This caused investors to be concerned whether the large fine will hit Deutsche’s capital reserves.

James also avoided Banco Popular given its low capital reserves. Another bank that he avoided is Austria’s Raiffeisen.

MGI’s Financial Contingent Capital Fund

Source: Fund factsheet

Assets of the fund have increased to around $310m from $100m when the fund was launched in August 2017, FE data shows.

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 €302.9m ($334.3m) in assets, and Bluebay’s Financial Capital Bond, which has $815.4m in assets, according to FE data. Both funds were launched in 2015.


The MGI Financial Contingent Capital Fund versus its sector, since inception

Source: FE Analytics. In US dollars. Note: the fund’s benchmark index, the Bloomberg Barclays Contingent Capital Western Europe (USD Hedged), is not available on FE.

 

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