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CoCos-risk and attractiveness

Many market participants might lack the necessary experience to understand the complexity of the Contingent Convertible (CoCo) asset class. This comes as no surprise when we consider the fact that the first CoCo was issued in 2009 by Lloyds following a recession, which harshly affected banks and their capital structures.

In a nutshell, these types of securities are designed to be loss-absorbing in cases where the rigorous banking regulations, which were put in place following the recession, are to be triggered.

For instance, if a bank holds this type of asset within its capital structure and its capital adequacy ratio – a measure of a bank’s capital, is lower that the necessary level implied by the banking regulator, this type of bond will be automatically converted to equity. This is merely an example, over the years the development of such financial instruments have evolved through various loss-absorption mechanisms.   

What is interesting is the remarkable growth of such asset class over the years, which has led to the construction of an index way back in 2013 by BoAML. According to 31 December 2017 figures, the CoCo market has now grown in excess of $200bn, with the index comprising of 149 bonds.

The CoCo asset class per se in 2017 closed the year with an impressive return of circa 14 percent. The remarkable performance was brought about by the attractive yield these types of bonds offered, in addition to specific names, which were being packed down by levels of idiosyncratic risk.

A typical example would be the 6.75 percent Unicredit bond, the Italian bank, which rallied following the restructuring of its capital structure through a successful rights issue, in addition to several impairments on non-performing loans.    

It is a state of fact that the CoCo asset class has its complexities and it is important to understand that they are very junior in the capital structure. In fact, financial professionals tend to consider such instruments as quasi equity. In this regard, the fundamental quality of the bank is critical and one needs to tread with caution when considering an allocation to such instruments.

Thus, in this regard, a thorough analysis, both on the legal offering documentation as well as on the continuous monitoring of the bank’s common equity, tier 1 levels and its distance from the trigger levels are imperative and crucial. In addition, it is also very important to monitor distance-to-coupon restrictions and the maturity risk. Furthermore, the trigger mechanics must be studied carefully to ensure that as an investor you are fully aware of the possible consequences.

In my view, the complexity of such asset class pushes investors towards other venues to generate sources of income. In addition, from a regulatory perspective, this is indeed considered a complex asset class, and thus, it might not be appropriate for all investors.

In such cases, given the attractiveness of such asset class as a source of generating income, one might want to expose himself to a fund, which indeed is involved in investing in such financial instruments. From experience, in 2017, the exposure to such types of assets was one of the prime contributors towards performance.

From an investment outlook preposition, given the recent tightening in yields within the CoCo asset class, price appreciation might be capped; however, income generation through interest payments is still attractive, selectively. As opposed to its initial days, way back in 2009, this asset class is less risky and it might still be a niche opportunity in the foreseeable future.   

Disclaimer: This article was issued by Jordan Portelli, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.

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