Regulators have been quick to stress the dangers of contingent convertible (CoCo) bonds in the retail market, but do these complex securities still have a place in institutional portfolios? Lynn Strongin Dodds investigates.
“These instruments worry me. They are volatile from an institutional point of view. For example, if there is a downturn we could see a higher default rate and a decline in bank capital ratios which could then trigger the conversion.”
James Foster
The Financial Conduct Authority’s (FCA) ban on the sale of contingent convertibles (CoCos) for the mass retail market is not dampening institutional appetite as the recent HSBC bond issue demonstrated. Only experienced players are allowed to take the plunge, the theory being that these savvier investors are better equipped than their less sophisticated counterparts to navigate the inherent risks.
The FCA is not alone and the European Union regulators have also chimed in about the risks of selling these instruments to retail clients. Their concerns are easy to understand. CoCos are relatively new fixtures on the investment scene and they are more complicated than the typical plain vanilla bond. They are hybrid subordinated fixed income securities that automatically convert into ordinary shares or are written off entirely if the issuing bank’s capital drops below a pre-agreed threshold. They have caught the imagination of yield hungry investors because of roughly 7% to 8% returns, which is higher than almost any other fixed income offering, including high yield and corporate hybrids.
However, the combination of the Ukraine crisis, a bulging pipeline and the bailout of Banco Espirito Santo underscores the dangers. These events, particularly the Portuguese bank’s bailout which threatened junior bondholders, triggered a sell off and virtually turned off the issuance tap in the summer. Some market participants though did not see this as a negative and welcomed the level of calm to what had become an overheated market. Serious investors stayed the distance and took advantage of the relative value on offer.
“From the retail perspective, these securities are risky and they are more intended for an institutional client base,” says Owen Murfin, fixed income portfolio manager at Blackrock. “CoCos are subordinated and riskier than senior bonds, but in most cases, the bank would also have to eat through a considerable amount of capital before the coupon or principal of the CoCo would be at threat.”
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