When discussing Contingent Capital bonds (CoCos) over the last couple of years, one question has been hard to counter: that since their creation in the aftermath of the global financial crisis, CoCos hadn’t been subjected to a truly stressed market environment. Without experiencing a crisis, how could the true worth and liquidity of the market be properly assessed?
Perhaps you should be careful what you wish for, as it’s hard to imagine a more difficult market environment than the beginning of this year. Given the extent of the global economic downturn that struck in the first quarter, you could be forgiven for expecting subordinated bank debt to be particularly badly affected. But, in fact, CoCos held up remarkably well throughout the March liquidity crisis and have performed strongly since then.
CoCos liquidity – now tried and tested
One important attribute of CoCos is the liquidity of the asset class, especially compared to wider high yield markets. In the depths of the crisis in March, investors trying to sell high yield bonds struggled for liquidity. When markets were uncertain about the scale of central bank and government support, high yield spreads widened significantly, and large parts of the market become difficult or impossible to trade.
In sympathy, CoCo spreads also widened, but their liquidity differentiated them. While sections of the high yield market had all but shut down, several investment banks reported that they were trading $500m-$1bn of CoCo bonds every day during the March crisis. For many funds and investment banks, CoCos were a point of liquidity that was unavailable in high yield and even parts of investment grade.
CoCos briefly became a victim of their success during this period, as investors desperate to raise cash had to sell what they could, but not necessarily what they wanted to sell. CoCos temporarily sold off partly because liquidity was available in this market but not in others.
Four reasons behind the resilience of CoCos
So why did CoCos remain relatively liquid, even exceeding our expectations? These are a few of the reasons behind the resilience of the asset class this year.
- Large nominal issues: Much of the issuance in the CoCo market is composed of large nominal issues. For example, one of the CoCos issued by HSBC (the largest issuer in the market) is $3bn and many other issuers also have issues in the $1-2bn range. This contrasts with high yield where, although there are larger issue sizes in the market, a lot of issuance is around $150-300m. This makes trading individual issues much easier as there is a wider pool of available holders if you need to cover a short.
- Instant name recognition: Most CoCo issuers are well-known national champion banks, so even investors without in-depth market knowledge will be aware of the latest news about these big-name banks. Again, this is very different from high yield where many bond issuers will be unfamiliar to a broad range of investors.
- Global market: Because of the name recognition of CoCo issuers the investor base is truly global, spanning across Europe, the Americas, the Middle East and Asia.
- A transformed industry: Over the course of the crisis, the regulatory approach to the payment of equity dividends and CoCo coupons has given the CoCo market a boost. Both are discretionary payments that can be halted by a bank at any time. As regulators looked to limit the payment of dividends during the height of the uncertainty earlier this year, the key question was: would CoCo coupons also be limited?
Fortunately, they weren’t. Banks were keen to continue to pay CoCo coupons as the market was a cheaper form of capital raising than equity, and the regulators made a clear distinction between CoCo coupons and dividends:
“There were some concerns that we might also consider other restrictions, including on additional Tier 1 instruments. Let me be clear: we are not planning to put any constraints on payments of such instruments.” – Andrea Enria, Chair of the Supervisory Board of the ECB
Many developed market banks have come a long way since the great financial crisis – balance sheets across all banks have shrunk, in some cases radically, and riskier businesses have been pared back, so that many now focus on core deposit taking and lending. That is why regulators have been keen to support the CoCo market as a tool for banks to raise money.
European Banks’ capital position (CET1 ratio):
Significant improvement since the financial crisis, providing higher buffers to economic shocks
Banks are virtually unrecognisable from their form before the global financial crisis. Many are now well-capitalised, with more stable revenues and much lower engagement in high-risk business lines. CoCos therefore continue to look attractive given the support from regulators, the liquidity of the asset class, and the much stronger position of banks compared to the previous crisis.
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