CoCos And How They Trade – Bond Structure Aspects

CoCos And How They Trade – Bond Structure Aspects by @creditmacro

Cocos… such a catchy term yet utterly bewildering to those unfamiliar with the asset class.

Cocos have been around for some 7 years now but many will only have come across the term in the past couple of years as returns have outweighed other asset classes and sharpe ratios have looked nothing short of a fixed income investors dream.  The concept was first issued back in 2009 by Lloyds and their ECN bonds, a tier 2 structured debt, with the slightly less catchy name of Enhanced Capital Note which offered racey coupons varying from 6-16%.  As the market and regulation evolved we moved from ECNs to Tier 2 Cocos and then onto their vastly big brother, the AT1 or Additional Tier 1. Fast forward a few years and add a large dash of regulatory capital targets, a mishmash of structures and north of 150bn issuance and we have ourselves the AT1 market.  The term Coco or Contingent Convertible Capital refers to a hybrid debt structure that is designed to absorb losses alongside the equity of a bank upon the bank falling below a targeted capital threshold.  This threshold is driven by the book value of Common Equity Tier 1 (CET1) capital as a percentage of Risk Weighted Assets (RWA).Most market participants, as the market and structures have evolved, have dropped the term Coco moving to the more suitable Additional Tier 1 terminology. … And we won’t even touch upon the concept of Coco squared which was flaunted to the market by the financial engineering brains at syndicate desks last year yet somehow never took off.

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Not a good start to investor understanding of an asset class when you already have a handful of names for a product with the same underlying aim!

How does it sit in the capital structure? In an uncomplicated format:

So now we have the simple definition (!) out of the way you may be asking why is there so much confusion?

Well the complexion lies in what is nothing short of an array of structures, in part due to approval delays across the broken up regulatory landscape of Europe, pre ECB taking over as sole regulator, but also a constantly changing regulatory environment.  Country regulators across Europe took many months, or years in some cases, to approve the AT1 structures as debt making their interest payments tax deductible thus allowing banks to boost capital (CET1) ratios at a cheaper expense than by simply issuing equity.

CoCos – Bond Structures Within AT1 Markets

When you hear the media talking about coco markets, in recent weeks in regards to Deutsche Bank, they are referencing the AT1 market.  Within AT1 markets we have 4 bond structures which have different outcomes for investors should the banks’ capital fall below a pre-defined trigger level:

  1. Equity convertible- around 40% of the market
  2. Temporary write down/up, whereby if the capital falls below the trigger level the bonds par level drops from 100 down to e.g. 85 until the banks’ capital level moves back above the trigger level- around 50% of the market and what Deutsche Banks “cocos” are
  3. Permanent write down, using the example above the bonds par value would stay at 85- around 5% of market
  4. Write off- around 5% of market

So if you’re still with me then next up is the trigger level… initially we had “low trigger” capital targets bonds (5.125% trigger) which were lower risk for investors but we have moved towards  “high trigger” structures becoming standardised (~7% trigger).  This part can add to the complexion of AT1 through the bank legal structures of Group and Holding Companies where in some cases AT1 bonds have dual triggers across the legal entities.

Then we have the coupon.  Now coupons in the asset class evidently had to be attractive to investors to account for the equity like risks and complexity of the product.  So whilst you would be getting 2% in your Corporate bonds or 3.5% in your subordinated financial debt, here were AT1’s offering investors 6-7% coupons… in the low rate environment you can see why they had such an appeal.  The Tier 2 cocos that we mentioned back at the beginning had mandatory coupons whilst the newer AT1 structures had non-cumulative coupons… issuer misses a coupon and it’s gone.

AT1’s are issued as perpetual bonds with callable features to suit the issuers funding needs and market appetite.  This callable feature adds another dimension to pricing and valuations- namely convexity.  In simple terms this infers the extent to which the market believes that a bond will be called at its next call date and as such coupons and repayment of principle is priced to that date. All well and good in cheap funding markets.  However, as we are seeing this now, the market has built itself into a state of fear as to whether bonds will actually be called at their first call date- this is negative convexity- the extension out of duration, or expected repayment of principle until either maturity or another call date further along the call schedule.  So for example if we take one of the SocGen AT1 bonds with a call in 2018, the market at the beginning of the year priced this bond with a duration of 2 years.. Fast forward to now and the market is questioning even the likelihood of the bond being called at the subsequent call date in 2023.  One aspect of this is the coupon reset levels post the first call date, also known as the back end; these are individual and vary dependent on when the bond was issued.  Some in the market are questioning whether the issuing bank will be able to refinance below the back end coupon reset levels and further if the regulator will allow them to do so- whether it makes economic sense.  The latter part being very open to interpretation- a lack of call on a bond and the market will question all and any future callable bonds the issuer has and increase their required level of return to account for the increased risk of non-call i.e. the bond being longer duration than expected. Hence the “economic sense” of a call or lack of cannot be viewed on the basis of just one bond but on the overall funding structure of a bank.  The earliest callable AT1’s are in 2018 and those bonds have very high back ends so are extremely likely to be called, thus you are looking at 2019 and onwards callable bonds to find out if the worry is warranted.  Its difficult to predict funding costs next week never mind >3yrs down the line hence you have to question the markets rational/thinking here.

Out with the above nuances Additional Tier 1s come in 750-1.5bn deal sizes, trade in minimum amounts of 200k and tend to come with call structures varying across 5, 7, 10 year parts of the curve. The bonds trade in cash price, unlike the bulk of credit markets which trade in spread, and tend to work on 50 cents bid offer.  As such, AT1 are a lucrative product to trade across bid-offer and they quickly became a favourite among the Street trading desks willing to provide high levels of liquidity where 10 to 25 million bids or offers were the norm at peak times.

Now that you have all the bond structure aspects that influence the price we also have the investor base.  Much like the structures the investor base has evolved over time, initially starting out as retail dominated in Lloyds ECN’s;  AT1s have moved far from that and to being an off benchmark play for institutional investors looking to turbo their returns.  Now dominated by asset managers, hedge funds, banks, insurers and pension funds with retail investors prohibited by regulators due to the risks and complexities.  Many investors took a long time to learn how to understand the risks, change mandates to include the non-benchmark structures and overall become comfortable with the product and how it trades.  Each AT1 has its own technical, whether that’s in the original investor base at primary issuance (sticky or fast money?) or its issuing bank being viewed as a higher beta name and a hedge fund hotel.  Additionally, the varying AT1 structures also dictate ownership; many European credit fund mandates simply do not allow equity and thus equity convertible AT1’s are un-investible.  This impacts large institutional buyers such as pension funds much like the AT1’s ratings, an Investment Grade rating and you have the support of a wider collection of investors who are unable to achieve similar returns anywhere else in their mandate.  The bulk of AT1 market however is High Yield rated and as such attracts “tourist” money both from corporate Investment Grade funds and from High Yield funds.  And this is where lies one of the issues with the AT1 market… it’s an off benchmark asset class with a small dedicated buyer base and so when times are good, AT1 is everyone’s best friend… when times are bad, index based investors drop their off benchmark overweight’s and return to benchmark weightings to avoid further underperformance.

In regards to hedging, this is very much changing as the product develops and is one of the reasons for the increased volatility across Deutsche Bank’s capital structure currently.  Credit Default Swaps which are the go to credit hedging product for bonds do not cover Additional Tier 1 debt and given not all AT1 convert to equity, equity is also not a direct hedge.  I should point out that the Swiss bank’s Tier 2 cocos are referenced in their subordinated CDS contracts but as the Tier 2 Coco product looks as if it has no future due to its now lack of accountability in capital ratios, the bonds will be called at their first call date.  Those pointing to hedging with equity have two problems, firstly as above, most fund structures in European credit do not allow for the ability to hold equity and secondly hedging with equity over the past few years would have been extremely costly, AT1 last year was incredibly stable, almost bullet proof in terms of volatility and returns, being bought on small dips and outperforming almost all asset classes- including SX7E the bank Eurostoxx index by ~7%.  In regards to CDS, the other structural issue is the lack of volumes and liquidity in CDS trading.  Due to a number of issues including the balance sheet costs for banks to now trade CDS vs pre crisis, the effectiveness of CDS actually triggering in a credit event (financials have had 3 recent events where the debt has collapsed yet the CDS has not triggered protecting  your losses) and lastly volumes in single name CDS is not what it once was leading to larger bid offers and increasing the cost to “hedge”.  The most liquid and cheapest to trade, CDS contracts in banks are now Senior hence we have Senior CDS contracts spike in pricing even in cases where this does not fundamentally make sense.  Away from single name CDS we have Itraxx index hedging for a broader credit market hedge which does trade in high volumes and low bid offer.

Finally it’s worth touching on negative convexity which is prominent in AT1 markets right now. Negative convexity affects callable bonds and occurs when the market starts to price in the expectation that they will not be called at their next call date.  If we take an AT1 with 5 year call and we think it’s no longer going to be called in 2021 and at best 2026, then we need to reprice the bond to take into account the added duration and risk.  In most cases as interest rates fall the ability of the issuer to refinance the debt at a lower price and call the outstanding bond increases but.. you may ask.. we are seeing interest rates fall this now so why are AT1 showing signs of negative convexity?  In this instance it’s the credit risk part of refinancing that is increasing at a faster pace and the worry that the current back end spread (the level that the coupon resets at post initial call date) will be lower than the refinancing cost of issuing a new bond- hence uneconomical to do so and may therefore be blocked by the regulator as discussed above.

In summary you’re looking at an average of 6-7% coupon at issuance for the lowest ranked debt in a bank’s capital structure with risks of failure to pay coupons, extended duration and principal being written down or wiped out completely. The market participants in this market are professional investors who should be fully aware of the risks- this is no longer a retail, mum and pop market.

Any further questions can be directed to @creditmacro