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.