It may blow hot and cold, but right now the CoCo is steaming hot .....

Thursday 1st September 2016

It may blow hot and cold, but right now the CoCo is steaming hot .....

ref:- "Investors grab cocos while the sun shines", The Financial Times, Capital Markets Analysis

We just love CoCos ..... as a topic of conversation you understand, not necessarily as a preferred investment vehicle. The fact that we regularly revisit them probably betrays our soft spot for these fellas, but the truth is that their position on the ladder of desirability can change so radically, and so quickly, that you can't help but be drawn to them. Right now Cocos are definitely "IN" ..... just six months ago, they were anything but.

By way of a reminder ..... CoCos (which from a regulatory point of view is Additional Tier One Capital, or AT1) are "Contingent Convertible Bonds", and were designed as a response to the 2008 crisis as one method of ensuring that the cost of any bank failure should be borne by investors in that bank rather than Joe Public ..... which seems fair enough. Essentially, a bank can issue bonds to investors which operate in the normal way until such time as the price of the bank's shares falls beyond a certain level, or say the bank is unable to meet its coupon (interest) payments. At that point, the bonds are converted into equity and thus the original purchasers of the bonds will be the ones taking their chances on the fortunes of the bank, not the taxpayer.

Back in February, when some of the biggest banking names in Europe in particular looked to be getting into strife and ultra-low and negative rates seemed to be questioning the future of the banking system as a whole, CoCos were the last thing any investor wanted on their books. Contrast that with August, when three UK banks (Standard Chartered, RBS and Barclays) issued somewhere just over $6 billion in CoCos between them. Bids for the new paper totalled more than $50 billion. You could say without fear of contradiction that CoCos are back in demand. In fact, a Markit Index for the asset class which was down 15% in February is now trading up on the year  --  all the more remarkable given that it took another beating immediately after the Brexit vote.

The most obvious attraction of these CoCos is the kind of yield available from them. You would expect extra risk to demand extra return, but the latest RBS issue pays a coupon of 8.625%. Never mind the slim or even negative interest offered on government debt, even the current yield offered by Barclays' pan-European High Yield bond index is a comparatively paltry 4% and change.

Things might have been a little different if the bonds had been issued in currencies other than dollars  --  VERY different in the case of the three British banks, most likely. They, and other issuers like UBS, have been able to take advantage of the global demand for US dollars judging by the origin of the bids for last month's issues. Standard practice now seems to be to issue in dollars and subsequently swap into other currencies.

Adjustments to the regulatory framework have also added to the attraction of CoCos, and that's something that didn't seem likely at the beginning of the year. Plainly the authorities were unnerved by the sharp sell-off in the first quarter, and some of the drop was put down to confusion over when exactly a fall in a bank's capital necessitates a suspension of coupon payments on its bonds. Last month, regulators responded by giving extra protection to coupon payments by prioritising them over dividend payments and bonuses. This is welcome news indeed for holders of AT1 capital.

Steady on ..... this is beginning to sound like a no-brainer. Unless you had particular concerns over the creditworthiness of a bank or banks, why would you be in anything else? Because nothing's that good, and there are other problems associated with CoCos (of course there are). The fact that issuance is well down on last year indicates that there's still a long way to go before confidence is fully restored to this particular form of investment. This lack of confidence translates into a lack of liquidity, and that's VERY dangerous if the market should get panicky again.

One could argue that rising requirements in bank capital over time will mean that holders of CoCos are better protected from the point when they are forced to watch their high-yielding bonds turned into plunging equity. Perhaps, but we're a long way from being able to call the risks associated with this market anything other than significant. That's why they can reward investors as well as they do, of course. But in a thin, even niche, market, you're in a position where large moves can be instigated by the actions of relatively few fellow investors. If the sell-off of earlier this year is anything to go by, that's not necessarily the safest place to be.