As new global capital rules bite, European banks are issuing more of what are called Cocos, or contingent convertible bonds. There could be headwinds ahead, however.

The so-called “Coco” market could expand to more than €200 billion ($214.8 billion) within a few years as banks tap capital markets to bolster their financial buffers, but the added supply means prices may struggle to achieve issuers’ objectives, according to Neuberger Berman, the asset manager.

Last year there was a large rise in the issuance of contingent convertible bonds – aka Cocos – by European banks. Such bonds convert to equity in the event of a specific trigger, such as a capital ratio falling below a pre-determined percentage, which explains their name. As new international bank capital rules take effect, banks have tapped the capital markets to achieve their targets. Capital rules have come into force under the international Basel system following the 2008-09 financial crisis.

Cocos are a type of hybrid capital instrument issued by financial institutions. They are designed to help a bank meet its capital adequacy and funding requirements, while at the same time achieving favourable tax deductibility treatment for coupon payments and equity credit from rating agencies. During normal markets, Cocos pay a coupon to their holders. However, during periods when banks are facing liquidity pressures or other market stresses, they can generate common equity automatically through either the write-down or the conversion of Cocos into shareholders’ equity at a predetermined share price. Hence, Cocos act as loss-absorbing capital.

“Cocos are highly attractive to issuers due to the significantly lower cost of issuance compared to equity, as well as their tax-deductibility. Given the current size of the European banking sector, the total size of the AT1 Coco market alone could reach over €200 billion within a few years. This would start to rival the size of the European non-financial high-yield market, which is currently €315 billion as at the end of March 2015,” Julian Marks, portfolio manager for non-dollar credit at Neuberger Berman, said in a note.

“The higher yields offered by Cocos, relative to similarly-rated corporate debt, make them attractive to investors. The main drivers of Coco returns this year should be the coupon, with potential for modest appreciation from spread tightening from the strongest issuers of this asset class that demonstrate growth in their regulatory capital ratios,” Marks continued.

“However, the strong demand and secondary market gains on new issues we saw in early 2014 is no longer present. Enthusiasm has declined somewhat since the Financial Conduct Authority announced product intervention rules restricting the distribution of Cocos to retail investors in August 2014. Though Cocos have continued to be sold to investors, they have mostly performed flat from new issue pricing, and traded along with the overall tone for risky assets,” he said, referring to the UK regulator.

In March, a firm called Axiom Alternative Investments launched a fund, Axiom Contingent Capital, which will hold Cocos, for example.

Neuberger Berman’s Marks said the has been a recent example of a Coco transaction that did attract strong demand - the inaugural UBS Coco in February 2015, issued in both dollars and euros. “This has performed strongly as UBS offered an attractive all-in coupon versus comparable instruments from issuers that have weaker capital ratios and lower overall credit quality,” Marks said.
What lies ahead

“As more banks this year will issue their first Cocos, and existing issuers will sell more Cocos to optimize their cost of capital, supply could be a major headwind for Cocos. The other risk with this instrument is that there has yet to be a conversion or a coupon cancellation. Should one of the banks have to cancel a coupon on their Coco, which would mostly likely occur with an equity dividend cancellation, the entire asset class is likely to underperform as investors will then demand a higher risk premium for this asset class,” Marks predicted.

“There are distinct differences between Cocos and typical senior debt which means it is critically important that investors understand the instrument they are buying. We focus on the issuer’s credit quality, preferring to remain in the strongest capitalized banks with business models that have low volatility of profits and less exposure to trading or investment banking businesses,” he continued.

“In terms of instruments, we closely track the progress of the firm’s capital ratios and aim to buy the instruments from issuers that have the potential to increase their capital ratios further mostly through internal excess capital generation. This, provides a larger margin of safety to the trigger level. Monitoring regulatory developments is also important as changes in risk weighted assets and other regulatory decisions increases the volatility of the bank’s capital ratios,” he added.