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Contingent convertible bonds – better than bank equity?

Fixed income portfolio managers Roger Wyss and Harald Kloos explain how contingent convertible bonds have evolved as an asset class and why they offer an attractive investment opportunity in the current environment.

January 21, 2021

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What is a contingent convertible bond?

R.W.: Contingent convertible bonds, often referred to as CoCos, are securities issued by banks in order to meet their regulatory capital requirements. Within the bank’s capital structure, CoCos sit right above common equity, but unlike other hybrid capital instruments, they have a contractual trigger level linked to an issuer’s capital adequacy ratio. If the level is triggered, the CoCo will be converted into ordinary shares or the principal will be written down. The idea is that the loss absorption will help reinstate the issuer’s capital adequacy ratio, although it does not provide additional liquidity. Given the clear subordination and the issuer-friendly embedded options in the security, this needs to be compensated with higher credit spreads, meaning the asset class offers relatively high yields. Currently, the average spread of CoCos offered by European banks is slightly above 424 basis points (bps).1

It is a relatively new asset class – how has it developed so far?

H.K.: CoCo issuance arose in the course of the 2008 financial crisis, with the aim of strengthening European banks’ balance sheets and raising solvency capital to meet  the Basel III capital requirements. They have since become an integral part of evolving regulatory reforms that have led to a significant reduction in the risk profile of banks, with substantially improved capital adequacy and reduced inherent capital volatility. The CoCo market is currently worth EUR 200 bn.1

Compared to other credit segments, contingent convertible bonds occupy a relatively small niche. Why has the asset class not grown even larger?

R.W.: The majority of the bigger European banks have now met most of their capital adequacy requirements, which would make additional issuances very costly and would reduce the net interest margin still further. We expect future issuance activity to proceed at a slower pace, mostly in favor of refinancing existing securities. From an investors’ perspective, the CoCo market is less crowded, given its complexity and technical considerations such as relatively high denominations. Consequently, CoCos offer an attractive investment opportunity.

Contingent convertible bonds saw quite a strong correction in March 2020, more pronounced than in most other credit segments. What is the reason for this?

H.K.: Fear of significant credit losses, uncertainty about the allowance of coupon payments on CoCos, lack of liquidity, and increased extension risks were the main reasons for the drop in valuations in March 2020. However, we consider the current COVID-19 crisis to be very different to the financial crisis in 2008, when the banks were undercapitalized and the source of the stress in the system. Banks are considerably better prepared for an economic downturn and entered the current phase from a position of strength, with average Common Equity Tier 1 (CET1) capital ratios now at 14%, compared to 7% in 2007.

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Considering these CET1 ratios, what is the risk of a bank falling below the contractual trigger level and investors facing a write-down or conversion to ordinary shares?

R.W.: Principal trigger levels on contingent capital are low, with the EU minimum set at 5.125% of CET1. Therefore, with CET1 ratios hovering around 14%, the average European bank would need to lose almost two-thirds of its capital to breach contractual triggers. In our view, this is a relatively remote scenario. In addition, a conversion or write-down can also be one of the tools used when a bank is deemed to have reached a point of nonviability (PONV). However, apart from Banco Popular in 2017, we have yet to see any major incidents that left CoCo holders facing the prospect of a write-down.

How has the asset class fared since the drawdown?

H.K.: CoCos have staged an impressive rebound since March 2020, and were trading slightly higher at the end of the year.1 The supportive monetary policy responses to the crisis from the European Central Bank (ECB) and other central banks have helped ease the strain on the banking sector. The measures announced in the form of TLTRO III and collateral easing have effectively assured central bank funding as long as the banks remain solvent. Additionally, the fiscal responses from local governments, together with the EU Rescue Package, continue to help mitigate the capital impact of an economic slowdown on banks. Finally, the ECB’s recommendation for banks not to distribute ordinary dividends (as opposed to coupon cancellations on CoCos) increased CET1 capital and should further reduce solvency risk.

Why is the performance in stark contrast to the recent returns on bank equities? 

R.W.: European bank equities, as measured by the EURO STOXX Banks Index, were down –24.48% last year1 and were not able to recover as strongly from their March lows as CoCos, which posted a total return performance of +5.13%1 for 2020. This illustrates that while investors seem unsure about the profitability of banks in the light of a prolonged economic slowdown and the low-rate environment, the solvency risk attached to CoCos is less of a concern. Historically, CoCos have outperformed bank equities with approximately a quarter of the volatility.

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Despite their strong performance in recent years and substantial recovery since the drawdown in March 2020, do you still see value in subordinated financial bonds?

R.W.: The CoCo market offers a yield of around 3.62%. To put that into perspective, European corporate bonds currently yield around 0.24%, and even European high-yield bonds come in at around 2.88%, so we definitely still see value in subordinated financial bonds. Importantly, CoCos have a shorter duration than European corporate credit. This provides less sensitivity to interest rate risk, which should be highlighted in the current low-yield environment. CoCo bond spreads currently trade at 424 bps,1 approximately 155 bps wider than their all-time lows in January 2018, which means they offer appealing spread-tightening potential.

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Risks

■ Credit risk: Issuers of assets held by the Fund may not pay income or repay capital when due. Part of the Fund's investments may have considerable credit risk.

■ Liquidity risk: Assets cannot necessarily be sold at limited cost in an adequately short timeframe. Part of the Fund's investments may be prone to limited liquidity. The Fund will endeavor to mitigate this risk by various measures.

■ Counterparty risk: Bankruptcy or insolvency of the Fund’s derivative counterparties may lead to payment or delivery default. The Subfund will endeavor to mitigate this risk by the receipt of financial collateral given as guarantees.

■ Event risk: In the case a trigger event occurs contingent capital is converted into equity or written down and thus may loose substantially in value. In addition, the Fund being predominantly exposed to financial institutions, adverse circumstances affecting this sector may cause material losses.

■ Operational risk: Deficient processes, technical failures or catastrophic events may cause losses.

■ Political and Legal risks: Investments are exposed to changes of rules and standards applied by a specific country. This includes restrictions on currency convertibility, the imposing of taxes or controls on transactions, the limitations of property rights or other legal risks.

This is not exhaustive list of risks. The product’s investment objectives, risks, charges, and expenses, as well as more complete information about the product are provided in the Prospectus (or relevant offering document) which should be read carefully before investing.

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Roger Wyss

Senior Portfolio Manager, Fixed Income
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Harald Kloos

Portfolio Manager, Fixed Income

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1 Data as of 31.12.2020.
Historical performance indications and financial market scenarios are not reliable indicators of future performance. It is not possible to invest in an index. The index returns shown do not represent the results of actual trading of investable assets/securities. Investors pursuing a strategy similar to an index may experience higher or lower returns and will bear the cost of fees and expenses that will reduce returns.
The shown yield to maturity is calculated as of 31.12.2020 and does not take into account costs, changes in the portfolio, market fluctuations and potential defaults. The yield to maturity is an indication only and is subject to change.

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