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Yield-Hungry Investors Take Their Chances with CoCo Bonds

Contingent convertibles issued by European banks offer attractive yields, but they’re subject to write-downs and regulatory tinkering.

Rarely has an investment provoked as much head-scratching and soul-searching as the contingent convertible, or CoCo, bond. A growing number of European banks have been issuing CoCos since Britain’s Lloyds TSB Bank devised the bonds five years ago as a way to boost capital in an increasingly strict regulatory environment.

The confusion among investors arises from the tension between the risky nature of contingent convertibles and the now cautious management culture of the banks that issue them — and from the mathematical difficulty of pricing an instrument whose risks are poorly understood.

“When the European Banking Authority drafted CoCo guidelines, we all said, ‘We’re never going to invest in that type of bond,’” recalls Filippo Alloatti, senior credit analyst at £28 billion ($44 billion) Hermes Investment Management in London. (The EBA, a London-based regulatory agency, released those guidelines in 2011.) “But it turned out that a grasp for yield, instigated by relatively loose monetary policy around the globe, made these products successful and salable to institutional and retail investors,” Alloatti adds. 

The CoCo market is worth about $90 billion in outstanding contracts. European banks have issued $31.5 billion worth of CoCos this year, according to Dealogic, more than double the $14.3 billion for 2013 as a whole. The Algebris Financial CoCo Fund, launched in 2011 by Algebris Investments, a London-based hedge fund firm, has seen its assets swell to about $1 billion following strong performance.

If all goes well, contingent convertibles act like normal bonds by paying a coupon. But at a defined trigger — usually if the bank’s ratio of capital to risk-weighted assets drops below the minimum demanded by regulators — they take a dramatic turn for the worse.

Some CoCos see their principal written down permanently. Others get written down temporarily but can be resurrected if the capital ratio rises again, whereas still others are converted into equity. Also, starting in 2016 the coupon payments of some types of contingent convertibles will be limited or suspended if a bank’s capital falls below a somewhat higher threshold than the trigger point that affects the bond’s principal.

Regulators have encouraged contingent convertibles because they boost banks’ capital and also help reduce interest obligations, or bolster capital, if a bank runs into trouble. Although CoCos have yet to suffer a write-down, the bonds’ sudden-death quality makes investors wary. When calculating write-down risk, the problem is that investors have to rely not only on the issuer’s performing well but also on the favorability of “exogenous factors” such as a lack of “regulatory intrusion,” says Alloatti of Hermes.

He cites decisions by regulators in recent years to hike the risk weightings of assets. Even if a bank’s capital remains stable, raising the risk weightings reduces its capital ratio.

In the case of Danske Bank, a higher risk weighting for mortgage loans in 2013 will progressively cut its capital ratio by more than a percentage point. In March the Copenhagen-based bank issued €750 million ($1.05 billion) worth of CoCos with a 5.75 percent coupon; the bonds will be written down if the common equity tier-1 capital ratio dips below 7 percent. However, the current ratio is 15 percent, far above the CoCo trigger point, even after allowing for new rules that might prompt further cuts.

Investors have responded to fears of CoCo write-downs not by avoiding them altogether but by demanding sufficient reward for the risk they entail. With yields of up to 7.5 percent for banks that are far from distressed, their rates look good compared with those of other bonds with a similar credit rating. Many CoCos are perpetual but have periodic calls, often every five years.

Ten-year dollar bonds issued by Ivory Coast, the politically troubled African country that saw some of its debt written off in 2009, yield about 6 percent, less than most European bank CoCos, notes Anke Richter, London-based credit analyst at $91 billion U.S. asset manager Conning & Co.

“If I had a choice between buying into the capital structure of a European bank or buying into Ivory Coast, personally I would prefer a European bank,” says Richter, who describes CoCos as “probably a medium-risk investment.” Ratings on the bonds are clustered around the double-B mark, just below investment grade.

“The banks are safer and more utilitylike than at any point in the past decade,” says Marc Stacey, portfolio manager at London-based, $67 billion BlueBay Asset Management, which plans to launch a fund benchmarked to the Bank of America Merrill Lynch Contingent Capital index by year’s end. The index currently yields 6.04 percent, with a total return of 6.3 percent since its January launch. For Stacey, the logical conclusion of this faith in the stability of banks’ future earnings is to move up the risk ladder from senior bank debt to CoCos — the paper yielding the highest return.

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