Investors polarised by latest coco bonds

Strong demand seen for recent issues by KBC and Barclays

Call them what you like – sudden-death, wipeout or total writedown bonds – the latest incarnation of the “coco” has some investors running for the door and others scrambling for more.

When Belgium’s KBC last month raised $1bn issuing contingent capital bonds that carried an interest rate of 8 per cent – an almost unheard of level in today’s low rate environment – investors hungry for yield flocked to the issue.

Now a spate of copycat deals is expected as regulators in Switzerland, Sweden, Denmark and the UK signal their support for a financial instrument that carries the risk of total loss for investors should a bank’s capital fall below a common measure of health.

How the recent contingent capital bonds perform matters because some regulators clearly see them as a good way to protect taxpayers and cushion the blow when a bank is on the verge of collapse. They prefer the new bonds to the original cocos, or contingent convertibles, developed after the financial crisis that converted to equity if banks hit trouble.

Yet, despite strong demand for recent issues, a growing body of investors argue that the latest incarnation of the coco not only distorts the natural hierarchy of who gets paid what when a bank goes bust, but potentially could make the financial system even more volatile.

“Investors are not completely comfortable with the idea of a permanent writedown structure – and one that makes them de facto subordinated to equity if the trigger level is breached. The jury is still out on that,” says Ivan Zubo of BNP Paribas.

What some investors do not like about the KBC and Barclays bonds is that they write down to zero once the bank’s common equity tier 1 ratio falls below 7 per cent. In effect bondholders get wiped out even as a bank remains a “going concern”.

Buyers of the total writedown structure point out they are rewarded for the risk. The KBC coco, for example, priced with an interest rate of 8 per cent, the Barclays bond 7.625 per cent.

“We are selective value investors in cocos and other subordinated debt,” says Satish Pulle, lead portfolio manager at ECM Asset Management, part of Wells Fargo group. He says picking the right bank is crucial, as is picking the right time to buy.

But other investors say the bonds really only favour the issuer.

“The nice thing about cocos [for issuers] is that you can have your cake and eat it,” says Christine Johnson, manager of the Old Mutual corporate bond fund. “The Bank of England explicitly said it wants banks to hold more capital. Banks don’t want to do rights issues. But what they do want is something that from the point of view of the regulator looks like capital but from a tax perspective acts like debt and they need something genuinely loss absorbing.”

Those holding cocos are there to be “sacrificed” when a bank fails, she says. “It subverts all laws of seniority. At least if it converts to equity you have a stake in the future of the company.”

There are other reasons for concern. Tamara Burnell, head of sovereign and financials credit analysis at M&G, says there are potential contractual risks involved in buying such bonds. The calculations for working out when an investor would be wiped out are not as clear cut as they may seem.

Contractual uncertainty could also stop the bonds working the way that banks and regulators expect. Banks could be open to litigation if bondholders decided to dispute whether and when the trigger had really been hit, she says.

High demand for KBC and Barclays cocos – as well as for short-dated Bank of Ireland cocos that were recently sold as part of Dublin’s unwinding of its investment in the bank – is encouraging other banks to issue coco-style bonds.

Possible contenders include Barclays, RBS and Lloyds, as well as Danish and Swedish lenders and Swiss banks such as Credit Suisse and UBS, both of which have already issued variations on the coco format.

Another factor in their success will be how Asian investors respond. There are signs that Asian appetite for hybrid deals from Europe is waning as concerns grow about overexposure and the complexity of deals.

Some analysts point to the performance of other hybrid deals from the Prudential and Axa, which plunged in value after issue, prompting concern over the impact Asian investors are having on deals.

The bigger issue, says Ms Johnson, is that “since the crisis, the stuff you could buy was reasonably good quality. It made the system resilient to downturns and shocks.” The worry now is that investors are being driven to buy ever riskier assets as they chase yield. “That makes the whole markets edifice very fragile.”

Additional reporting by Paul J Davies in Hong Kong

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