It has been volatile two months for CoCo bonds investors. It was the first time broad market heavy sell-off since CoCo bonds come alive a few years ago. There was a moment that some investors in the market really connecting Deutsch Bank (DB to Lehman Brothers. It is the growing pain for CoCo bonds and the good thing about this sell-off is everyone starting to ask what CoCo Bonds are and why they exist. It used to be a niche market product, now it is in the spotlight.
So what are CoCo bonds? Why people think they are risky? And why I think market is over- concerned and there are opportunities within this asset class.
CoCo is short for Contingent Convertible. Contingent means there is a possibility. Convertible means if possibility becomes reality, then CoCo bondholders will take losses according to predetermined terms.
There are two triggers that may trigger the loss absorption function embedded in CoCo Bonds. One is the contractual trigger. This usually means a threshold for issuing bank's CET1 capital ratio. Take DB CoCo bonds as example, the threshold are all 5.125%. So if DB phased-in CET1 ratio dropping below 5.125%, the CoCo bonds' principal will be temporary written down to the extent that DB CET1 ratio restored to 5.125%. (The write down amount can be discretionary reinstated and written up, subject to certain limitations)
Another trigger is also called PoNV (Point of Non-Viability). This usually means the relevant regulatory authorities have the statutory bail-in power and they can ask CoCo bondholders to take losses according the relevant laws. In other word, even DB phased in CET1 ratio is well above 5.125%, German regulatory authorities can impose losses on DB CoCo bondholders if they think the action is necessary. Although there is no formula to predict authorities' action, but judging from common sense, regulatory authorities will be very careful to use the bail-in power, given the huge impact and implication.
Trigger risk is the first major risk for CoCo bondholders. But this risk is not really a concern to the market. After years' efforts, most banks today are much stronger than they were before the global financial crisis. For example, DB has phased in CET1 ratio consistently above 13% since first quarter 2014. According DB Q4 2015 result, the buffer to trigger is 8.075% which is roughly EUR 32billion. Pretty Safe.
The second major risk for CoCo bondholders is coupon cancellation risk. CoCo bonds can be senior bonds, Lower Tier 2 (LT2) bonds or Additional Tier 1 (AT1) bonds. If a CoCo bond rank senior or LT2, the coupon payment is mandatory. But most CoCo bonds are AT1 bonds. For them, coupon payment is at discretion of the issuer. To make things worse, under some circumstances (like Insufficient Distributable Item, or solvency event occurs, or if payment exceeds Maximum Distribution Amount, or required by authorities), even the issuers want to pay the interest, they are forbidden to do so (mandatory coupon cancellation). Cancelled coupon payment is non-cumulative.
It is really the second major risk that hits the financial market in Jan/Feb. Everyone is worried that DB can't make the coupon payment on their CoCo bonds. The coupon payment amount is actually just EUR 350mln on 30 April 2016. Why can't DB pay 350mln euro given its pro forma Jan 01, 2016 CET1 ratio 12.9% is well above the minimum regulatory requirement 10.75%.
Because although the high CET1 ratio well above regulatory requirement, DB 2016 CoCo payment capacity is estimated to be just approximately EUR 1 billion only. That EUR 1 billion also depends on DB 2016 operating results under German GAAP and movement in other reserves. So to figure out the payment capacity on DB CoCo bonds, investors not only need to figure out the intricate distributable item formula or Maximum Distribution Amount in the bond prospectus, but also need to understand German GAAP. This is simply too much.
It is not only DB. Most AT1 CoCo bonds have similar structure or language. It was from 01 Jan 2016 that the SERP requirement is first broadly applicable in European bank industry. Some investors didn't really follow regulatory changes. Other investors just simply assume buffer to coupon cancellation is simply the difference between CET1 Ratio vs. minimum regulatory requirement. DB case clearly caught a lot of people in surprise. It is just impossible for most investors to assess the coupon payment capacity on AT1 CoCo given the complex formula and different local accounting methodology. This is the No.1 reason behind the sell-off.
To emphasis, DB may be forbidden to pay the CoCo bond interest. It is not DB can't afford to pay the interest. It is more like an accounting issue than a liquidity issue. Every issuer wants to pay CoCo coupon given the reputation risk and disastrous implication. The market turmoil clearly caught attention of ECB. They are studying to loosen the mandatory coupon restriction or to make it more clear and easy for market participates to assess. Once we have clarity on this, it will remove a big overhang for CoCo.
The third risk for CoCo bondholders is the redemption risk. Beside the optional redemption right, issuers also have the right to redeem CoCo bonds if there is capital event or tax event, usually at par. Or they can substitute or vary the contractual terms without consent from CoCo bondholders (given the new terms not materially less favorable to CoCo bondholders). This is a risk for CoCo bonds that trade well above 100. (Recent legal case Lloyds Bank vs. CoCo bondholders is a perfect example on redemption risk.) It is not a risk to consider today as 90% CoCo bonds currently trade below Par.
So although fundamentally (not including mark to market risk) CoCo bonds have three major risks, these risks are either remote (loss absorption risk), or decreasing (coupon cancellation risk), or not applicable today (redemption risk). There are two additional reasons which support my view that CoCo is an asset class worth exploring.
The first reason is certainty. Although considered to be high risk, CoCo is actually an asset class with great certainty. Issuers are more transparent now and they disclose adequate information. With this information, investors can calculate buffer to trigger and buffer to coupon restriction. Once you get all the numbers and closely monitor the regulatory development, CoCo becomes quite clear and predictable. Compare CoCo bonds with other HY bonds like miner, retail, you will see CoCo is in a much better position and offers similar or better yield with great certainty.
The second reason is the relative value. CoCo offers the best risk reward opportunity within Banks' capital structure. Compare with CoCo bonds, banks' senior debt are too tight. In the meantime, banks are dropping or cutting their dividend. It is a bad time to be banks' shareholders as the management are putting (or required by regulators to put) balance sheet strength as their top priority, rather than creating shareholders' value. CoCo is the least known asset class within banks' capital structure and it is best positioned to benefit from banks' continuing balance sheet improvement.
CoCo bonds are still relative new and growing. There will be growing pain before they become a major asset class. The growing pain creates unique opportunities for investors. In a zero rate environment, global or domestic systematically important banks offer you 7%, 8% or even 10%+ yield. It is definitely worth a look.
Invest when things aren't perfect.
Disclaimers and note: We have been following CoCo market since its inception. We have developed a mobile app specifically for CoCo bonds. It is called "CoCo Monitor". It has all the information you need. It is a great platform for interested investors. Check it out in Apple Store or scan the QR code below.