Midsized Europe periphery banks set for cocos push

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Europe’s midsized periphery banks are preparing to join the region’s high risk, high return convertible bond bonanza as investors become bolder in their search for yield.

Italy’s Banco Popolare is looking at issuing its first contingent capital bond later this year as it seeks to bolster its balance sheet without issuing new shares, according to people close to the situation.

Created in the aftermath of the financial crisis to absorb bank losses, the market for contingent capital bonds – dubbed cocos – has more than doubled in the year to date to €11.4bn, according to financial data provider Dealogic, but has so far been dominated by large financial institutions.

“The national champions opened the markets and smaller, domestically focused banks follow up – it’s natural,” said one London-based debt banker. “The investor base is growing faster than pipeline.”

Spain’s Banco Popular last year became the first midsize periphery bank to issue the debt instrument, which can either convert to equity or be written down, temporarily or permanently, if capital levels fall below certain thresholds. Cocos yield on average nearly 6 per cent, according to an index from Bank of America Merrill Lynch.

Other, second-tier banks in Italy and Spain are also considering issuing cocos, according to capital markets insiders. These people say midsized banks in these countries are looking at raising additional capital compliant with Basel III regulations and the latest European Union capital markets rules as their older debt instruments expire.

Analysts predict up to €50bn of coco bond issuance this year, while Morgan Stanley estimates the market could eventually reach €250bn as new global capital rules take hold. Deutsche Bank last week attracted more than €25bn of demand for its first €1.5bn coco, allowing the German bank to reduce the interest it paid to entice investors into the instruments.

However, despite robust investor appetite for the debt instrument, the Bank of England raised concerns in November that investors were mispricing the risks embedded in some cocos.

“They are absolutely idiotic because there is no residual value [if a bank defaults],” said Davide Serra, founder of Algebris, a London-based hedge fund which invests in some cocos. “They create contagion in the capital structure [of a bank]…the idea that a bank have a bond written-down to zero when shares are still trading is crazy.”

Unlike older hybrid bonds, the coupon on a coco is not necessarily guaranteed, meaning bond investors could find themselves in the unusual position of not receiving a payout even as the bank remains a going concern.

Regulators are also able to step in and forcibly convert cocos if they believe a bank is in trouble, even if the lender has not breached the terms of the coco it agreed with investors.

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