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Europe’s regulatory system proves it works, even with a loss

In an era of painfully low yields on government and other high-grade bonds, investors have spent much of the last decade looking into all corners of the debt markets for better returns from their fixed-income portfolios.

Bond yields reflect the potential risk associated with a projected return, so the prospect of better returns should always remind an investor that there is greater risk.

One category of subordinate bonds — contingent convertible bank debt, so-called CoCos — became popular in 2014, giving banks a way to raise regulatory capital. Investors liked them for their yields, which were higher than other similarly rated corporate debt.

Overall the Bank of America Merrill Lynch Contingent Capital index has returned 6.34% year-to-date, 11.13% over one year, 5.37% over three years and 6.28% over five years, through June 7.

The risks inherent in these bonds were considered significant enough that in July 2014, the European Securities and Markets Authority felt the need to issue a statement to specifically point them out to institutional investors.

“Investors should fully understand and consider the risks of CoCos and correctly factor those risks into their valuation,” the ESMA warning states.

ESMA and market analysts, as recently as last week, pointed out that each issue of CoCos is different and that analysis has to be done carefully, and that issuer selection in the sector is paramount to help mitigate the idiosyncratic risks that abound.

And last week, in the first real test of Europe's post-financial-crisis bank resolution rules, the risk played out.

Spain's Banco Popular Espanol SA was swallowed up by that country's largest bank, Banco Santander SA, in a move driven by regulators to avoid a collapse.

The European Central Bank declared Banco Popular to be failing on June 6, and by the morning of June 7 the deal was done. The failed bank's branches opened for business. Deposits were available. Markets did not panic. There was no taxpayer bailout and seemingly no political fallout.

The system worked. It is a victory for Europe's Single Resolution Board on its first outing.

On the other hand, investors in Banco Popular's equity and CoCos, or additional Tier 1 debt, will get nothing. Senior unsecured bondholders were luckier. Those obligations are to be transferred to Santander. This marks the first time CoCos, designed for exactly this purpose, have been wiped out.

The roughly €2 billion in outstanding CoCos are held by dozens of money managers, including Pacific Investment Management Co. LLC and parent company Allianz SE, along with BlackRock (BLK) Inc. (BLK), the world's largest manager.

None of those entities had any comment immediately after the news of Santander's takeover.

But it is clear that based on the amount of debt involved as compared to the assets each has under management in high-yield bonds, this will have little affect on overall performance.

What is also clear is that these securities, while not a growing sector, will continue to be available. Moody's Investors Service reported that CoCo issuance in the first quarter of 2017 reached $16 billion, up 5% from the same quarter in 2016, but down more than 40% from the first quarter of 2015.

So it remains important for investors to remember the system worked, but even when it works, there are risks. Investors need to remember not to invest in something if they don't fully understand — or can't handle — the risk, even if they are dazzled by the returns. n

This article originally appeared in the June 12, 2017 print issue as, "System worked, even with loss".