High yields with investment grade security mean contingent convertibles can offer investors a unique opportunity in today’s higher interest rate environment – if you have access to expert analysis and execution.
For information purposes only. Any views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
Since their creation from the ashes of the global financial crisis (GFC), contingent capital bonds, or cocos, have become fundamental to banking capital. But despite being a commonplace of bank financing — the coco global market exceeds $240 billion — many investors are wary of the asset class. This, however, means investors risk missing out on a unique opportunity.
Cocos, also known as Additional Tier 1 capital, are undoubtedly an unusual instrument. The underlying issuers are investment grade banks, yet the potential returns are high and often exceed high-yield bonds. It is this unusual combination that makes cocos an attractive asset in the current climate.
Lloyd Harris, Head of Fixed Income and manager of the team behind the Premier Miton Financials Capital Securities strategy, which invests in cocos, says the unusual nature of these assets created a “coco complexity premium”, but it is a premium Premier Mitons Fixed Income Strategies aims to capture with a team dedicated to close analysis and a highly active trading strategy.
“We don’t just sit on these bonds, we are truly active and that has served us very well over recent years,” says Harris.
Banking on the fundamentals
Cocos emerged in the wake of the GFC, and their function is captured concisely in their name. Issued as fixed rate debt, cocos act as a buffer to bank capital. In the event of a bank’s tier one capital falling below a pre-determined trigger level, the coco converts to equity or is wiped out, depending on the particular case. In the capital structure, cocos rank above equity, but below other debt instruments.
The key attraction lies in the yields. “For sterling denominated cocos there’s a broad range of yields from between about 7% to, in some cases, 13% or 14%,” says Cameron Geering, Credit Analyst.
Understanding the risk hinges on a fundamental analysis of the banks issuing cocos. Memories of the 2009-10 banking crisis still linger for some investors, but Geering says the fundamentals of the sector are now stronger than they have ever been.
“In the last 14 years, we have gone from very loose banking regulation to very tight regulation. Meanwhile, today’s higher interest rates are also good for banking margins and banks are making better profits than they have for some time. So, the backdrop to cocos is that bank earnings and balance sheets look robust,” Geering adds.
In effect, Cocos are a type of high yield bond, where the issuer typically becomes more financially secure when interest rates rise.
Swiss exception proves the rule
The crisis that engulfed Credit Suisse in 2023 cast a brief shadow over cocos, but the lasting effect may ironically have been to reassure markets.
As the bank teetered on the brink of collapse in March 2023, Swiss authorities intervened to change a law around contingent convertible capital. The effect was to wipe out the value of Credit Suisse cocos while still retaining some equity value in the bank.
While the Swiss move caused unease among some investors, it was swiftly followed by public statements from other financial regulators making clear that they regarded the Credit Suisse case as an aberration.
The European Central Bank and the European Banking Authority stated that the regulations set out in the wake of the financial crisis regrading cocos would be strictly applied: “In particular, common equity instruments are the first ones to absorb losses, and only after their full use would Additional Tier 1 be required to be written down.”
The Bank of England issued a similar statement, and more recently, the head of US banking regulator, the Federal Deposit Insurance Corporation, described the Swiss regulators actions as “unhelpful”.
Harris argues that the swift response from other regulators was reassuring.
“We’ve seen regulators saying they would not have handled Credit Suisse in the same way and that gives us a lot of confidence,” he says
Coco market still thriving
The market, too, appears to have been reassured. To date in 2024, cocos worth $6.9bn have been issued in the US, while the Europe and the UK figures are €7.4bn and £1.8bn respectively. A healthy volume of new issues is an ideal opportunity for Premier Mitons Fixed Income active strategy, which aims to invest flexibly across the yield curve, actively seeking the best available returns and generating actionable investment ideas.
In their relatively brief history, cocos have grown to become a key pillar of banking capital, offering yields far above those that might be expected for the investment grade risk involved. They have endured a few bumps in the road, but in practice, those bumps have served to clarify regulation and even to increase confidence in the coco model.
There are complexities to be overcome when investing in cocos – including the need for quality analysis of the issuing banks and of the specifics of each instrument. But, says Harris, with the right partner to provide the expertise, the opportunity is striking: high yields with investment grade risk.
