Contingent convertible bonds (CoCos) are a source of funding for banks that act like debt during good times and convert to equity if banks come under stress. Satish Pulle, Senior Portfolio Manager, Head of Financials – Europe, WFAM Global Fixed Income, discusses the asset class.
Laurie King: I’m Laurie King, and you are listening to On the Trading Desk®. Contingent convertible bonds, or CoCos, are an asset class that provide banks a source of funding. They are designed to absorb losses if banks come under too much stress and are commonly issued by banks in the European Union. But CoCos can be complex and require deep understanding to navigate the asset class and unlock potential for investors.
Recently, Satish Pulle, Senior Portfolio Manager, Head of Financials – Europe, Wells Fargo Asset Management Global Fixed Income, provided his insights into the asset class and explained how his team unlocks potential for investors. Satish and his team sit in London, keeping close watch on the European banking system.
Satish Pulle: Our team, our financials credit research and investment team, is a global team with deep and varied experience. It’s a seven member team with a combined experience of something like 128 years.
I feel that what differentiates us is that we’re not afraid to be different from the herd. Whether it comes to, you know, avoiding the UK just before the Brexit vote, avoiding Italy just before their election—in many, many, many ways, over the last several years, we have shown that we are not afraid at all to be very different from the herd.
Laurie: Contingent convertible bonds—CoCos—and the Global CoCo Bond Index started in 2014 at $50 billion and have climbed to around $200 billion today. CoCos arose from the financial crisis of 2008.
Satish: Banks, and to a lesser extent insurance companies, are allowed to issue CoCo bonds as replacement for a proportion of their equity capital requirement. A CoCo is a financial instrument, which combines the features of an equity share and a bond. A CoCo can provide permanent capital to a bank. There are call dates, but no fixed maturities.
The European Regulatory Capital directives give the banking regulator the authority to prevent CoCo coupons from being paid if a bank is unable to meet regulatory capital requirements, despite regulator’s warnings. In addition, if a bank’s regulator judges a bank is failing, the regulator can write down, partially or completely, the CoCo bond’s principal amount, to recapitalize the bank, or convert it into equity.
And CoCos have complex features. So really, what we’re helping investors to do is to invest in a complex sector and to harvest that complexity yield premium.
Laurie: CoCos are higher risk instruments than senior bank bonds and typically tend to be rated in the very low investment grade area, or what some consider high yield. Like high yield, quality matters, because quality factors into the likelihood they’ll pay back debt—no matter where the structure is issued.
Satish: For example, HSBC. As we all know, HSBC is rated very highly; in the case of Moody’s, the rating is A-2 at the senior unsecured level. However, HSBC CoCos are rated by Moody’s as B-AA3, just one notch above sub-investment grade. Of course, the opportunity as investors is getting paid a higher yield to own bonds by the same issuer, but at a lower level in the capital structure. For instance, the senior HSBC bond with a six-year maturity and a five-year call yields about 4% in yield currently, and I’m talking about U.S. dollar bonds here, whereas the HSBC CoCo, again a U.S. dollar CoCo, with a perpetual maturity but a five-year call, yields more than 6%.
Laurie: Satish goes on to explain what differentiates CoCos from corporate high yield.
Satish: First is that the default cycling for banks and insurance companies follows a much longer 30- to 40-year cycle. Corporate high yield, on the other hand, follows the well-known five- to 10-year economic expansion/recession cycle. We would expect that the return profile is also different over time. The financial sector issuers tend to be larger, as well, and they tend to have access to equity markets. Regulators are keeping a very close eye, for instance, through stress tests; annual stress tests and so on. And finally, what is much less appreciated is that higher interest rates are good for banks. Higher bond yields, government bond yields, are good for the insurance companies. Neither is great for your typical corporate high-yield issuer. So you know, for all these reasons, we expect the correlation of CoCos to be low relative to corporate high yield.
Laurie: That shows the importance of knowing what you own, and that requires in-depth credit research.
Satish: Even though the ratings are lower, and our work has shown, that the risk of a CoCo coupon loss is extremely low. Using HSBC again as an example, for the UK regulator to force HSBC to cancel a CoCo coupon, the bank would have to suddenly lose $42 billion and remain unable to raise capital or sell non-core businesses. This is a true Armageddon scenario, particularly given the extensive balance sheet restructuring and cleanup HSBC has done post-crisis.
Effectively, these are high-yield bonds and they should be given the analytical attention that high-yield bonds need, but we still feel that, for the vast majority of the sector, the risk of a CoCo coupon loss is extremely low, and of course, the risk of a write-off is just much, much lower.
Laurie: We’ll end this episode on that note and thank Satish Pulle for his insights. Learn more about his team and their approach by visiting http://on.wf.com/6125DLrkW. Until next time; I’m Laurie King, take care.
The ICE BofAML Contingent Capital Index tracks the performance of investment grade and below investment grade contingent capital debt publicly issued in the major domestic and eurobond markets. You cannot invest directly in an index. Copyright 2018. ICE Data Indices, LLC. All rights reserved.