Anthony Smouha, manager of GAM Star Credit Opportunities comments on the FCA’s CoCos announcement…
The FCA’s announcement that banks in the UK will be banned from offering contingent convertible bonds (‘CoCos’) to ordinary retail investors from October highlights the complexity of these securities. As companies become more creative in the structures they use to raise capital, more detailed and careful analysis is required to assess the investment case for individual issuances.
Fundamentally, the regulatory pressure for financial institutions to become ever more safe and solid is unrelenting. European banks are striving to become as strong as possible ahead of the asset quality review/stress tests, the results of which are due in late October, leading to increased issuance of CoCos. However, it is important to remember that the purpose of these restrictions is not to undermine the issuance of additional Tier 1 or Tier 2 capital, but to make sure that these instruments do not end up in the wrong hands.
If banks become more robust, as they should, the extra yield CoCos offer is worth having. The issues are often attractive from an interest rate perspective as they can be structured so that if interest rates rise, the new issues have coupons refixed after a number of years, mitigating interest rate risk. However, investors must remember that CoCos are complex instruments with often vastly different terms and conditions and a plethora of small print that needs to be examined in great detail. The instruments have the capacity to absorb losses (via conversion into share or a write-down of the principal) if a financial institution fails to meet a predetermined level of capital. As such, it can be regarded as a form of automated measure to swap debt into equity, if needed, in order to prevent troubled financial institutions being bailed-out, instead being bailed-in via the private sector.
We believe there is even better value on offer in the older style legacy subordinated debt. As the supply of these securities is limited and is diminishing due to companies calling these bonds or offering exchanges for new-style instruments, demand is pushing up prices. Within this environment we continue to search for opportunities in the secondary market, where there are still bargains to be found. For example, investors can obtain nearly a 7% yield on old-style Lloyds securities, and the holder also benefits from the additional protection of seniority above all the new additional Tier 1 capital. In addition, regulatory capital regimes may prompt companies to buy back the securities or offer an exchange at a premium to market prices.