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COCO Bonds

 

Ever since the Global Financial Crisis of 2008-09, the interest rate environment has remained at or near historic lows. However, as years go by, more and more investors are shifting from their working years towards their retirement. The need for income-producing investments will very likely only increase in the coming years.

 

Key features:

 

  • CoCo’s have an interesting risk/reward trade-off and are issued by large European banks. To compensate investors for bearing the risks of this asset class, these banks issue CoCo’s with higher coupons.
  • European banks are incentivized to issue high-yielding AT1 CoCo’s to meet stricter capital requirements following the Global Financial Crisis.
  • Since inception, AT1 CoCo’s have outperformed both Eurozone Investment Grade Credit and Eurozone High Yield Credit.
  • The return profile of AT1’s has exhibited relatively low correlation to other major asset classes (both bonds and equities) and can be used to achieve greater portfolio diversification. 

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What are AT1 CoCo Bonds?

 

AT1 stands for Additional Tier 1 Capital. This is the layer of a bank’s capital structure which can be treated as counting towards their Tier 1 capital requirements, otherwise reserved for common equity and retained earnings. This layer of the capital structure is intended to absorb losses in the event of severe market stress and serves as a cushion between equity and more senior debt.


To meet Basel III capital requirements drafted after the Financial Crisis, European banks began issuing Contingent Convertible Bonds. Depending on the terms and conditions, a CoCo is classified as either AT1 or Tier 2 (T2) Capital. A few unique features of CoCos are that they have a trigger and a loss absorption mechanism. A CoCo trigger is the prescribed level which, when breached, activates the loss absorption mechanism. The loss absorption mechanism is the action taken thereafter.


AT1 CoCos offer a higher yield than other bank debt since they are lower on the capital structure, right above equities. From the issuers’ standpoint, CoCos are attractive because the coupon payments are fully tax-deductible and the cost of raising capital by issuing an AT1 CoCo bond is lower than it is for a share capital increase.


Summary of European Bank Capital Structure 

 


Simplified illustration of capital structure from WisdomTree.


Universe of AT1 CoCos

 

The market for AT1 CoCos has evolved and grown considerably over the past several years as banks phased in capital requirements under Basel III. As of January 2018, the AT1 Coco universe has expanded to €140 Billion and includes debt issued by European financial institutions. The largest issuers in the universe are HSBC, Barclays and Société Générale. 

Many of the European banks are international and have revenue sources coming from multiple countries. Consequently, CoCos are issued in multiple currencies, primarily USD, EUR and GBP. Almost half of the universe are bonds denominated in US Dollars.  

The AT1 CoCo index is composed of 20% IG and 80% high yield. About half of the AT1 CoCos have an equity conversion provision while the other half have a Principal Write-down provision.

Although CoCos are perpetual, they are callable after five years. CoCos have a fixed-to-float coupon structure. After the first call date, AT1 CoCo coupons become floating and adjust higher if interest rates were to rise. The floating-rate back-end effectively limits the asset class’s sensitivity to interest rates after the fixed-to-float transition occurs. Of course, we couldn’t say that CoCos have zero interest rate risk, and it is noteworthy that the market, as of yet, hasn’t seen a large number of these transitions because the asset class is so new.


Learn more about Negative Duration Bond Funds

Get the facts about AGND

 

1Bonds with ratings of BBB-/Baa or higher are considered investment grade.

2Interest rate risk: The risk that an investment's value will decline due to an increase in interest rates.

Why Invest?

AT1 CoCos have an attractive risk-reward profile. The AT1 CoCo index is composed of debt issued by large European banks whose senior bonds are generally rated investment grade. To attract investors to their junior subordinated debt, banks issue CoCo bonds with higher coupons than more senior bonds. Fixed income investors looking for high-income products should consider an allocation to AT1 CoCos.

While coupons on IG corporate bonds may be between 2-4%, coupons for AT1 CoCos are generally between 4-7%. Banks are incentivized to issue high yielding AT1 CoCos to meet stricter capital requirements following the Financial Crisis. 

AT1s carry additional credit risk since they are lower on the capital structure and coupons are entirely discretionary.

 

 

In this example, the yields for AT1s CoCos are higher than the yields on Subordinated Debt by almost 2%. This is due to the Loss Absorption mechanism of the AT1 CoCo. In this example AT1s offer about 30bps less yield compared to equity dividend yield, and they are higher on the capital structure.

 

Since inception the AT1 asset class has generated strong returns for investors

 

 

Past performance is not an indicator of future returns.

 
 
 
 
 
 
 
 

 

As of January 2018, the one year return on the AT1 CoCo index was 7.4%. Since inception the asset class has return 10.3% annually. The one-year, the three-year and since inception AT1 CoCo returns have outperformed both EUR Investment Grade credit and EUR High Yield credit.

 

Returns are calculated using monthly returns in EUR including for AT1 CoCos, listed in USD and for US High Yield. The EUR Equities asset class is referenced by the STOXX Europe 600 TR. The EUR Bank Equities asset class is referenced by the STOXX Europe 600 Banks TR. The AT1 CoCo asset class is referenced by the iBoxx Contingent Convertible Liquid Developed Europe AT1 Index. The EUR T2 CoCo asset class is referenced by the iBoxx EUR Contingent Convertible Liquidity Developed Markets T2 Index. The US HY Corp asset class is referenced by the ICE BAML US High Yield Index. The EUR HY Corp asset class is referenced by the ICE BAML Euro High Yield Index. The EUR IG asset class is referenced by the ICE BAML Euro Corporate Index. The EUR Banking IG asset class is referenced by the ICE BAML Euro Banking Index. The EUR Govt asset class is referenced by the ICE BAML Euro Government Index. 

Past performance is not an indicator of future returns.


How are AT1s Helpful in a Portfolio?


The return profile of AT1s has exhibited relatively low correlation to other major asset classes (both bonds and equities) and can be used to achieve greater portfolio diversification. AT1s are a high-income product and investors generally use AT1s as an out-of-benchmark fixed income allocation.

 


Correlations are calculated using monthly returns in EUR including for AT1 CoCos, listed in USD and for US High Yield. The EUR Equities asset class is referenced by the STOXX Europe 600 TR. The EUR Bank Equities asset class is referenced by the STOXX Europe 600 Banks TR. The AT1 CoCo asset class is referenced by the iBoxx Contingent Convertible Liquid Developed Europe AT1 Index. The EUR T2 CoCo asset class is referenced by the iBoxx EUR Contingent Convertible Liquidity Developed Markets T2 Index. The US HY Corp asset class is referenced by the ICE BAML US High Yield Index. The EUR HY Corp asset class is referenced by the ICE BAML Euro High Yield Index. The EUR IG asset class is referenced by the ICE BAML Euro Corporate Index. The EUR Banking IG asset class is referenced by the ICE BAML Euro Banking Index. The EUR Govt asset class is referenced by the ICE BAML Euro Government Index.

Past performance is not an indicator of future returns.

 

The returns of AT1s have been most highly correlated to EUR Equities, US High Yield Corporates and EUR T2 CoCos. Notice the correlation between AT1s and EUR IG Corporates is only 0.44. Notably part of the increased correlation between AT1s and US High Yield is related to currency. More than 50% of AT1s are denominated in USD.