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Explaining CoCos and their appealing returns

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Shilen Shah, Bond Strategist, IW&I writes on CoCos, or Contingent Capital Securities.

Shilen Shah, Bond Strategist, IW&I writes on CoCos, or Contingent Capital Securities. CoCos are bonds that are primarily issued by banks that can count as a bank’s core capital. When a bank’s capital falls below a certain predetermined level, these bonds either convert in to equity or are written down. Lloyds was the first bank to issue CoCos during the financial crisis in 2009, and many other banks have followed suit.
 
Since the end of the financial crisis, regulators have been increasing capital requirements for the banking sector, with the result that core capital ratios are now significantly higher in both the US and Europe.  Higher capital levels for banks mean that the likelihood of either conversion or a write down being triggered is now relatively remote, with the strongest banks being especially resilient. Returns from CoCos are now looking good. The current redemption yield of the CoCo index is around 6.3 per cent which is very attractive in a zero return world.
 
The returns for those investing in CoCos contrast to those experienced by bank equity holders, as the sector itself is facing structural pressures that could last for several years such as low and negative interest rates, flat yield curves and persistent misconduct fines. Bank CoCos do not need rising profits or increased dividend payments for their investment rationale to work.
 
Active investors in CoCos can achieve alpha through analysis of the individual characteristics of the bonds, such as the trigger ratios and overall capital position of the ban. For many investors, the CoCo sector is an alternative to bank equity as returns are heavily skewed towards coupon payments, rather than changes in bank equity valuations, which for a number of banks have been very volatile.  
 
Over the last twelve months, the CoCo market has also experienced volatility. There has been regulatory uncertainty around the Maximum Drawdown Amount which relates to triggers associated with distributions (rather than conversion or loss absorption), and the market has reacted as investors became concerned that they would be hit for unforeseen coupon suspensions. ECB clarification around this issue has, however, led to an increase in investor confidence and a rebound in the asset class since the first quarter of 2016.
 
Deutsche Bank had for many years been a poster child of the European banking sector, especially before the financial crisis. However in the post-financial crisis regulatory environment with a higher capital requirement and structural issues, it has come under pressure. Relative to its European peer group, it remains very dependent on investment banking and trading revenue which have come under pressure recently. This weak level of profitability combined with a high cost to income ratio has meant organic capital generation has been hampered. The most recent market shock, however, relates to conduct issues that occurred in relation to US mortgage backed securities, with the US Department of Justice indicating that it was seeking a settlement of USD14 billion as its first negotiating position. This is significantly higher than Deutsche Bank’s provisioning for conduct-related charges and has the potential to eat into the group’s capital, with the coupon payments on the group’s CoCo securities at risk of a temporary suspension. Given the high level of uncertainty in relation to the final settlement it is reminder that active stock selection remains critical for those investing in the CoCo sector.
 
Over the last two years the CoCo index has a correlation of -0.06 with the BofAML EU Government Bond Index and +0.6 with the MSCI Europe and Europe Banks indices. In effect, this has meant that despite the asset class being nominally classified as fixed income, its return profile has generally been more sensitive to equity-risk rather than government bonds. However, one potential benefit of the above mentioned ECB clarification is that the asset class may over time become less correlated with equity-risk as investors focus on its underlying credit fundamentals. Given the potential for further investor disappointment with bank equity, the CoCo sector continues to look attractive given the yields on offer. We also believe that improvementsin banks’ capitalisations and regulatory clarity, combined with a relatively high income and lower volatility, makes CoCos an attractive investment in this low yield environment.
 
 

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