Rules on listing Coco bond ETFs changed after first approvals

Regulators appear to have got cold feet after approving two funds investing in the niche bank debt central to losses in the wake of UBS’s takeover of Credit Suisse, but allowed the existing funds to continue.

Two exchange traded funds, the €1.1bn Invesco AT1 Capital Bond Ucits ETF (AT1) and the $265mn WisdomTree AT1 CoCo Bond Ucits ETF (CCBO) invest 100 per cent of their assets in “additional tier 1” bonds issued by banks.

These “contingent convertible” bonds were introduced after the global financial crisis and designed to limit the need for taxpayers’ money to be used to bail out failed banks. They provide an additional layer of loss-absorbing capital that is junior to traditional debt instruments in a bank’s capital structure but, it was widely thought, senior to its equity.

However, Credit Suisse’s $17bn of AT1 bonds were written down to zero as part of its takeover by Swiss peer UBS, even as equity holders shared SFr3.25bn ($3.53bn) between them, prompting an outcry from investors and concerns over the wider $260bn AT1 market.

Prices had already been marked down earlier this month after AT1 bonds issued by Silicon Valley Bank UK were written off, although in that case equity holders were also wiped out.

Despite recovering from their lows, after the likes of the European Central Bank and Bank of England reiterated their view of AT1 bonds’ place above equity in banks’ capital structure, the Invesco ETF has fallen 19.4 per cent since March 9, while the WisdomTree fund is down 15.5 per cent over the same period.

As of the market close on March 17, the last trading day before Credit Suisse’s demise, the ETFs had exposure of 3.5 per cent and 2.8 per cent respectively to the bank’s AT1 bonds, according to Morningstar data.

Both ETFs are domiciled in Ireland and launched in 2018. However, in 2020 the Central Bank of Ireland, the financial regulator, issued new guidance for Ucits funds, Europe’s mainstream funds structure.

This said that Ucits funds proposing to invest in contingent convertible bonds “may be subject to enhanced scrutiny at the authorisation phase with a view to ensuring that the proposal is appropriate”.

Cocos were lumped in with contracts for difference, collateralised loan obligations and binary options as assets requiring a similar level of surveillance.

The regulator said in a statement that, in respect of Cocos “the central bank’s authorisation approach has evolved whereby any fund proposing to invest a material proportion in such assets will be subjected to enhanced review.

“Any proposal for a Ucits to invest a proportion of assets in such assets is required to make a comprehensive submission at authorisation stage which addresses issues around the fund’s liquidity profile and ability of the fund’s management company to effectively manage the proposed level of investment.”

In particular, this enhanced review would consider how holdings of Cocos “will be managed in terms of overall liquidity of the fund, particularly given the potential for strong volatility in the liquidity profile” and the disclosures that would be given “in order for retail investors to understand the inherent risks in these assets”.

European retail investors typically do not hold Coco bonds, and are barred from doing so in some jurisdictions, such as the UK, although it may be possible for UK investors to access the ETFs.

Ireland’s change of tack came after the European Securities and Markets Authority said in 2019 that, in its view, “Coco bond funds are generally not compatible with the retail market,” with these “investor protection concerns” extending to “funds which predominantly invest in Coco bonds”.

“Manufacturers and distributors should therefore consider excluding retail investors from the target market,” Esma added.

The pre-existing Invesco and WisdomTree ETFs were, however, permitted to continue operating.

“These funds are grandfathered,” said one industry figure, referring to the legal exemption that can be granted for entities to continue existing operations after the imposition of new rules. The person believed the CBI’s revised guidance was a de facto ban on the creation of any new ETFs investing more than a small slice of their assets in additional tier 1 bonds.

“The CBI changed the rules. They haven’t allowed any more AT1 ETFs, they will only allow people to put 10 per cent of a Ucits fund in AT1s,” he said.

The figure believed the CBI had been wrong to change tack, arguing there are many other fixed income ETFs that hold “some pretty illiquid securities”, while theoretically riskier equities, even those in emerging markets, where volatility is typically elevated, are freely available to retail investors.  

Peter Sleep, senior portfolio manager at 7 Investment Management, agreed, arguing there are many securities “wrapped up in exchange trade funds or notes that are not approved for retail investors such as commodities, cryptocurrencies and Vix-based ETNs, all of which are available in levered long and short versions” and all of which have proved volatile.

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Kenneth Lamont, senior fund analyst for passive strategies at Morningstar, went further, saying: “I think it’s great that these [Coco] products exist, allowing sophisticated investors to make targeted bets very cheaply and efficiently.”

Coco bonds are “a market that would once have been accessible only to the largest and most sophisticated investors globally. Now it’s also available to smaller institutions and other intermediaries who know what they are doing,” Lamont added.

He argued that “much more dodgy” ETFs are widely available, such as leveraged and cryptocurrency funds.

Lamont’s view was that ETFs such as the Invesco and WisdomTree products should be available, but that access to them should be policed by brokerages and other intermediaries, which should ensure that their products are suitable for their investor base, and that risk warnings are in place if these funds are available.