Contingent convertible debt survives rocky ride

Despite huge volatility and a big drop in performance at the height of the pandemic, contingent convertible bank debt remains on top of some money managers' lists for maintaining — and in some cases increasing — allocations.

The Bloomberg Barclays Global CoCo Banking TR Value Unhedged USD index dropped 15.4% in the month of March alone, at the height of the coronavirus pandemic. The market for issuance of these debt securities, which convert to equity under certain trigger events, effectively shut down, sources said. While the index rebounded 8.7% in April, European issuance did not resume until May. Monthly CoCo issuance has now reached levels close to those seen before the outbreak of COVID-19, according to information provided by the Association for Financial Markets in Europe, while the index has returned 3.2% for 2020 through Sept. 2.

And in a sign of market conditions stabilizing, the cost of debt paid by banks has declined recently, an AFME spokeswoman said. The weighted average coupon rate of newly issued CoCos as of late August was 5.5%, down from 5.9% in the second quarter. However, that figure remains above the pre-COVID-19 level of 4.6% in the first quarter, she added.

Many managers took the opportunity to add to their holdings as prices collapsed and, due to a belief that CoCos remain an attractive exposure, will keep on buying bank debt. Most CoCos qualify as additional Tier 1 bonds, known as AT1s.

"We are adding to positions in CoCos, but selectively," said Jan Willem de Moor, senior portfolio credit manager at Robeco Institutional Asset Management BV in Rotterdam, Netherlands.

The firm had been overweight the banking sector for some years, although had reduced that a little as spreads recovered. Robeco runs €155 billion ($182.9 billion) in assets.

"But now, with the (recent) CoCo issuance, we think it can be attractive ... as yields everywhere are getting close to zero or negative," while CoCos are offering a coupon of 5% or 6%. "That sounds like a very high number," Mr. de Moor said.

CoCos make up about 5% of eligible strategies. While that's not a huge allocation, "in terms of risk it can be an important part of the portfolio," Mr. de Moor said. CoCos AUM is about €850 million across different strategies.

Amundi executives also bought CoCos after the sell-off, in part because of the type of risk they add to portfolios, said Gregoire Pesques, head of global credit in London. Amundi runs €1.6 trillion in assets with €2 billion of the firm's flagship strategy is run in subordinated debt.

"In terms of opportunities, duration is flat — there's little to no additional incentives to go very long duration at this point in the market. The ideal situation is to go down the rating spectrum to take more credit risk, (but that is) more difficult to access than before in the cycle," he said.

CoCos offer a different type of risk — "subordination risk. Most of the issuers in the subordinated world are investment-grade issuers, very well-known issuers, where the default risk is extremely low," Mr. Pesques said.

"With the normalization we have been adding CoCos," in particular due to government guarantees that have been put in place for new loans in the crisis and also because "there is still a good run for this asset class, so that's the reason why we are — where (able) — long CoCos" and subordinated debt, he said.

BlueBay Asset Management LLP has an off-index allocation in its investment-grade benchmark strategies to AT1s of around 5% to 6%. Multiasset credit strategies, which can invest across fixed-income assets, have about 15% in CoCos, while the $1.2 billion BlueBay Financial Capital Bond Fund is almost exclusively invested in AT1 securities at the moment given the "attractive opportunity in this part of the capital structure.

Allocations were added to in March when valuations got to attractive levels, said Marc Stacey, partner and senior portfolio manager in London. The firm runs more than $60 billion in assets. The firm doesn't split out CoCos AUM.

"Part of the reason why we like banks as a sector is because … banks have spent the last 10-plus years cleaning up their balance sheets, reducing non-performing loans (and they have) also increased the amount of liquidity and market capital they have on their balance sheets. They were entering this economic shock in far better shape than certainly in the last crisis," Mr. Stacey said.

Bank balance sheets are better capitalized too. "This time around, they are the conduit that will really be the transmission regulators (use) to support the real economy. They are going to be part of the solution," he added.

And spreads are attractive. In euro terms AT1 spreads had a pickup of 145 basis points vs. euro-denominated BB-rated bonds as of Aug. 28, while dollar-denominated AT1 bonds were picking up 72 basis points vs. dollar-denominated BB-rated bonds. "This is completely counterintuitive to us, as in an economic shock we're likely to see default rates pick up to a large degree. (That would) impact more cyclical, high-yield names, but the national champion banks that are extremely well-capitalized, profitable, are likely to be far less cyclical and more robust in the wake of what we're experiencing than the market expects," Mr. Stacey said.

He puts it down to markets and investors being "still somewhat scarred by 2007-'08 and when they see the economic drawdowns ... (they) think banks are likely to go the same way."

One major thing going for CoCos since the crisis came from a move by the European Central Bank as part of its coronavirus relief measures and efforts to keep the banks supporting the economy. The ECB said in March that banks could "partially use capital instruments that do not qualify as Common Equity Tier 1 capital," such as AT1s, to help meet capital requirements.

The move brought forward changes set to come into effect in January next year under the Capital Requirements Directive V.

The change "essentially permits the bank to issue more CoCos in order to cover Pillar 2 (bank capital) requirements," said Filippo Alloatti, London-based senior credit analyst at Federated Hermes Inc. "Before it was only to be covered with common equity, and now (supervisors have) opened the gates to permit the banks to issue AT1 to cover this shortfall." The $628.8 billion firm does not split out its CoCos AUM.

Added Gildas Surry, London-based portfolio manager at Axiom Alternative Investments: "There is a clear incentive for banks to issue additional amounts of capital instruments." Axiom runs €1.4 billion in assets, with the majority invested in subordinated debt and CoCos.

Some banks have already taken advantage of the new rules — particularly since it is cheaper to issue debt than equity to fill capital requirements, managers said.

And while bank shareholders have suffered from the impacts of the COVID-19 crisis, with regulators putting a blanket ban on dividends, AT1s did not go the same way. Issuance has returned to pre-crisis levels and is expected to grow.

Issuance of CoCos is about €25 billion year-to-date. "There has been a bit of new issuance lately...to do with certain factors that are not the case for other asset classes like high yield, investment-grade or bank senior papers," said Felipe Villarroel, partner, portfolio manager in London at TwentyFour Asset Management LLP. The firm has kept its allocations steady, replacing called bonds with new issues or other outstanding AT1s. TwentyFour AM runs £19 billion ($24.9 billion) in assets. The allocation to CoCos is about 18% across portfolios.

Despite the positives, some investors still have concerns over CoCos, which are perpetual, have no fixed maturity date and have call dates when the bank repays the bond. Industry participants had questioned what might happen should a bank decide not to call its CoCo bond, but since early last year the market has seen several banks — including Banco Santander SA and Deutsche Bank AG — make the move.

"The reputational damage (of non-calls) is very limited — the rules are now clear: A call has to be on economic terms" for the bank, Mr. Surry said.

Initially, investors were worried that a non-call would cause problems, Amundi's Mr. Pesques said. "We had (a non-call) and it was not a big drama. People get more comfortable," he said.

However, what would cause reputational damage would be a decision to skip a coupon, managers said.

The market "is not prepared for the skipping of any coupons...It's fair to say times will come where we will see (it)," Federated Hermes' Mr. Alloatti warned.