"I SHOULD COCO !" ...

Wednesday 22nd February 2017

"I SHOULD COCO !" ..... British rhyming slang from the 1930s, a notable 1990's album by Supergrass, and for the last 12 months a pretty successful investment plan.

ref :- "Holders of coco bonds rack up gains", The Financial Times, Markets and Investing, Capital Markets.

You remember CoCo bonds, don't you ? Full title : Contingent convertible bonds, and otherwise known as Additional Tier 1 capital ? 

Regulars will know that we like to keep an eye on these fellas, not least because of their origin as a clever and very pragmatic wheeze dreamt up by the banks as a method of raising capital in the dark days immediately after the Financial Crisis. In the event of a bank getting into trouble, bond holders would see their investments converted into equity  --  the intention being that such instruments would greatly reduce (we can't say eliminate) the chances of the state having to bail out failing financial institutions.

Plainly there are additional risks in investing in this type of convertible bond, so they offer generous fixed coupons in return  --  typically between 6% and 8%. That sort of income would be pretty attractive to most investors in the modern, low-yield era, PROVIDED THAT they were confident in the financial solidity of the issuer. Sadly, that's not always the case .... not by a long chalk. You might well point out that these instruments might never have been invented if robust financial health was a given in the banking sector, and just 12 months ago owning cocos looked anything but advisable.

At that time the sector was under the severest market pressure as the ultra-low growth, low interest rate environment brought the ongoing sustainability of various banking models into question. A Deutsche Bank coco bond was in the eye of the storm when uncertainty arose around both Deutsche's ability to make coupon payments and more generally around the rules governing the cancellation of such coupon payments.

Despite Deutsche's insistence that doubt about their making the payments was nonsense, their bond traded down to 71 cents on the Euro  --  well, that kind of panicky speculation can generate a momentum all of it's own. And now ? That bond is trading at 91 cents, a gain of nigh on 30% and pretty representative of cocos as a whole.

An investor-friendly clarification of the rules regarding when bond issuers should cease to make payments helped this impressive rally of course, but in the main the prime mover behind it is the improving fortunes of the banking sector. In Europe, fear of deflation is slowly being replaced by cautious optimism over growth and a return to some healthy but mild inflation, which in turn will eventually prompt some long-awaited upward movement in interest rates. Both growth and the prospect of higher rates are just what the banks might have ordered, and since last February the Euro Stoxx banks index has risen 28%.

Moreover, the impetus from across the Atlantic promises to be helpful to the sector. If there are misgivings about some of Mr Trump's likely policies (for want of a better word), a stimulative fiscal programme and an intention to cut back on expensive and restrictive financial regulation bodes well for banks, and the effects are bound to be felt in Europe and elsewhere.

Does that mean that even after a 30% gain there could be more to come for cocos ? James Goldsmith once said that if you see a bandwagon, it's too late. Well,..... often that's true but the rally in cocos "still has legs" according to analysts at Blue-Bay and Morgan Stanley, though they would qualify their views with caveats regarding any unexpected results in upcoming European elections starting next month in the Netherlands. As an asset class they still look cheap against other high-yield and corporate bonds, and the spread between their yield and the yield on risk-free debt is still higher than in the past.

What you need to buy these things now is a little faith ..... faith in continued recovery, faith in higher rates, faith in the banks and faith in the predictability of electorates. Not too much to ask, is it ?