Where are we now, and how did we get here?
The last couple of years have been challenging for investors. Just as it looked like markets had recovered from the shock of the COVID-19 pandemic, they were rocked by the Russian invasion of Ukraine. The volatility this has caused has been widespread in both the equity and fixed income markets. However, one asset class which has held up relatively well throughout the uncertainty has been Contingent Capital bonds, also known as CoCos.
Why have CoCos held up so well? Firstly, European banks are in a strong capital and liquidity position as the credit quality of the banking sector has improved since the Global Financial Crisis, due to many banks simplifying their balance sheets and de-leveraging. European banks have also benefitted from supportive monetary policy from central banks, especially through the COVID-19 pandemic. The improved liquidity and easy access to cheap finance helped the banks to stay resilient throughout the crisis. Of course, this is now reversing, as the fed has begun to hike rates and enter a period of quantitative tightening. However, the positive effects of the more accommodative period of monetary policy and deleveraging efforts have put European financials in a strong fundamental position and given them resilience with which to deal with the volatility we are seeing from the Russia/Ukraine crisis.
Another factor that has helped banks, and European financials in particular, has been the change in regulatory policy following the financial crisis. Regulation is much tighter now, with regulatory accords such as Basel III forcing banks to accumulate a substantial amount of capital and to reduce the risk profile of their activities. It has also led to more stringent liquidity requirements, meaning that banks must have sufficient liquidity during periods of financial stress. As a result, many European banks are in their most financially resilient position ever.
Resiliency through crises
The shocking events in Ukraine have caused significant volatility in equity and fixed income markets, especially within high beta sectors such as financials. However, European banks actually have very limited direct exposure to Russia which has partially helped to protect them from a lot of the volatility. Importantly, even banks with some exposure to Russia have continued to pay their dividends and CoCos coupons, with the exception of one bank which has suspended the 2021 dividends but did not even consider to stop CoCos coupons. This has gone a long way to reassuring the market.
The CoCos market has now been through two crises – the COVID-19 pandemic and the current Russia conflict – and the asset class has held up remarkably well so far. For example, even during the height of the pandemic, many banks were forced to cut their dividend payments, but none stopped paying their CoCos coupons. This is a good sign for subordinated credit investors, and it demonstrates how reticent banks are to negatively impact the CoCos market.
CoCos offer better yield and ratings profile compared to High Yield
Source: ICE Baml indices, as at 28.02.22
Investing in a rising rate environment
High levels of inflation and rising interest rates mean that it is a challenging time to be a fixed income investor. However, there are some features of CoCos which mean that the asset class may be better positioned to perform in this environment than more traditional fixed income instruments. Firstly, CoCos have on average a relatively short duration (to their first call date), which can help in an economic environment of rising rates and high inflation. This is due to the fact that short duration bonds are less sensitive to rate increases than longer-duration bonds that are locked into rising rates for a greater period of time. The average duration of a CoCos bond is below 4 years – this gives investors the ability to be more flexible and reduces the sensitivity to potential rates volatility.
Another factor for investors to consider in the current environment is that CoCos currently offer an attractive yield compared to more traditional forms of bonds such as Corporate High Yield and with a better rating profile. With the inflation debate still raging, investors are expanding the hunt for a reliable high-yielding investment product. Therefore, we think CoCos will continue to provide superior returns to traditional bonds while offering a better risk profile during periods of uncertainty.
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