CoCos – a surprising haven
After the explosion in corporate bond spreads in February and March last year as the pandemic wrought economic devastation across the world, corporate and high yield bond markets have delivered extraordinarily strong returns in the aftermath of that risk-off move. This has largely been driven by unprecedented levels of fiscal support from governments to the wider economy, as well as targeted support to credit markets from the major central banks, which has ensured the continued flow of finance to companies across the globe.
As a result, the investment grade and high yield bond spreads that had ballooned in March 2020 to the widest levels seen since the Global Financial Crisis, had by February 2021 retraced all of that widening and more, with both markets delivering double-digit returns over 2020.
However, the first quarter of 2021 has been a more difficult environment for credit markets. Investment grade indices have delivered significantly negative returns and high yield is only barely in positive territory (see Figure 1), as risk-free bond yields have continued to rise, and credit spreads have seen the tightening trend stall. With investment grade and high yield bond spreads at, or close to, their tightest levels seen for the last 20 years, significantly more spread compression is difficult to forecast and so finding value and potential returns in credit markets has become a more difficult process.
But one area within credit markets that continues to offer value is the Financials Contingent Capital market, also known as ‘CoCos’. The higher yield of CoCos and the improving investor attitude to the asset class has shown them to be – perhaps surprisingly – something of a haven from rising risk-free bond yields and stagnant spreads (see Figure 1).
Figure 1: Financials Contingent Capital bonds vs high yield and investment grade
Source: Bloomberg, as at 14 April 2021.
Also, despite rising inflation expectations, CoCos have remained resilient during the recent sell-off in US Treasuries. We think this is because financial conditions remain broadly supportive as evidenced by low-to-negative real yields that remain at all-time lows. For CoCos to come under pressure, we would expect real yields to have to rise materially above current levels. From a fundamental perspective, the rise in nominal yields and subsequent steepening of the yield curve provides a tailwind for bank profitability as margins expand. In our view, these dynamics should continue to provide support to the asset class in 2021.
Why CoCos’s are a mispriced market
We think the CoCos market is undervalued from several perspectives.
The credit quality of the banking sector has improved dramatically since the Global Financial Crisis, with significantly improved capital levels and capital ratios, yet this continues to be an underappreciated trend. Banks are still leveraged institutions and caution and in-depth analysis must always be the starting point when assessing the credit quality of any issuer, but it’s also worth noting that the change in the regulatory environment has been enormous. Western European banks have increased their Common Equity Tier 1 ratios from around 6.5% on average in 2008 to around 14.5%, balance sheets are cleaner, and leverage ratios substantially improved.
The liquidity of the CoCos market in absolute terms and relative to other credit markets is also noteworthy. We have often highlighted liquidity as a key benefit of the asset class, and it passed a significant test during the crisis in February and March last year when many parts of the high yield market became difficult, if not impossible, to trade and even sections of investment grade credit endured challenging trading conditions. In contrast, CoCos held up remarkably well and have performed strongly since then.
Since the start of the crisis, central banks have outlined their support for the CoCos market, realising that it was crucial to reassure wider markets. This does not mean that they looked to suspend the existing trigger levels embedded in the securities, but rather sought to remove any speculation around potential suspension of CoCo coupons, as we saw with the limits imposed on bank equity dividends last year. More specifically, regulators made a clear distinction between CoCo coupons and dividends, saying:
“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, May 2020
As a result, banks remained keen to continue to pay CoCos coupons throughout the Covid crisis, realising how important it was to keep access open to this market, which represents a cheaper form of capital raising than equity.
Finally, CoCos have continued to look relatively attractive to other sectors of the credit market (see Figure 2).
Figure 2: Oasis in the yield desert – CoCos vs other credit market segments
Source: ICE BaML indices, as at 13 March 2021
Only CCC-rated credits, which are one notch away from default, offer a higher yield than CoCos and from our perspective the yield premium to single B-rated credits (around 40bps) is hard to justify.
At the same time, the underlying credit quality of CoCos is significantly better than in many sectors of the single-B space. The international banks that issue into the AT1 market are better known by a wider global investor base, providing a liquidity profile that passed the severest of tests during last year’s crisis– in addition, central banks are keen to ensure this new asset class continues to work efficiently.
By all these measures, CoCos look mispriced compared to other areas of the credit market. For those investors still searching for yield but cautious about liquidity as they travel down the credit curve, we believe CoCos are a market well worth serious consideration.