Remember the commercials featuring Sonny the Cuckoo Bird going absolutely nuts and repeating the phrase, “I’m cuckoo for Cocoa Puffs!” after eating a spoonful of the chocolaty goodness? In some sense, that’s been investors’ behavior for any investment offering yield in today’s low-yielding market. To give you a high-level illustration of why investors are yield starved – the yield on the 10-year U.S. Treasury in 1963 (the year Sonny first appeared in Cocoa Puffs commercials) ranged between 3.80% and 4.15%, while today the yield is only around 2.60%. This shift is making it challenging for fixed income-focused investors (retirees, pension funds, and insurance companies) to achieve their desired yields. As a result, they are moving out the risk spectrum into riskier credits or down the capital structure into higher-quality credits. Interestingly enough, that brings us to an exciting new opportunity – CoCos.
CoCos, which is short for contingent convertible capital securities, is an asset class in its infancy. Basically, CoCos are the product of the fallout from the recent global financial crisis. Global banking regulators, as an extension of their politicians, are determined to end “too-big-to fail” bailouts that place taxpayer money at risk. Many regulatory authorities view CoCos as part of the solution. CoCos are essentially bonds that either convert into equity or are written down based on the capitalization of the issuing banks. These bonds are designed to absorb losses as a bank spirals toward failure with the hope that they’ll either help save the bank from insolvency or reduce the amount that governments may ultimately need to inject to prevent a larger systemic crisis. We expect regulators in a number of jurisdictions around the world to eventually require a certain percentage of CoCos in banks’ capital structure in order to provide this important loss-absorbing buffer. This requirement has potential to expand the CoCo market as banks issue these securities over the next few years.
But why would investors buy these securities? Going back to my earlier statement, investors are hungry for yield and are willing to take risk when they can be compensated. For instance, the yield on the Barclays Investment Grade Corporate Index is around 3.09%, the yield on the Barclays High Yield Index is around 5.70%, and the yield on an index that tracks CoCos yields around 6.20%. The interesting thing to point out is that the banks that issue CoCos are generally rated investment grade (i.e., AAA to BBB-), while the specific CoCo security they issue may or may not be investment grade after the rating agencies take into account the subordinated nature of the security and the security’s probability to absorb losses. So an investor can essentially get exposure to an investment grade issuer with additional compensation for the probability of loss and the expected recovery in the event of a loss. New regulations that force banks to hold higher capital and liquidity than they have in the past, ultimately lowering the probability of loss, are helping investors gain more comfort around this new asset class.
To date we’ve seen an estimated total of over $70 billion worth of CoCo securities issued, which is a relatively modest amount. However, the issuance we’ve seen thus far is far from standardized, which complicates the analysis. Based on global regulations requiring banks to issue these types of securities, the market could grow to upwards of $500 billion! The typical investors, thus far, have been retail investors, private banks, asset managers, and hedge funds. Insurance company involvement has been more limited, in part, due to the regulatory capital treatment of these securities. Despite the hesitation of some investors, the deals we’ve seen come to market have done fairly well, with orders well in excess of bonds offered and generally higher secondary prices. Already we’ve seen two Wall Street firms construct benchmarks to track the performance of CoCos, which should encourage more investors, notably large institutional investors. One of the obstacles to increased demand is the lack of standardization in the terms of each bond. We’ve already seen a pretty wide variation, from differences in triggers, subordination, calls, loss absorption mechanism, etc. We expect demand to pick up further as institutional investors gain more comfort with the asset class, as the industry coalesces around more common terms, and as additional benchmarks are created to track performance.
Overall, while certainly not as tasty as Cocoa Puffs, CoCos represent an exciting opportunity for investors willing to carefully analyze both the credit of the issuer and the terms of the specific CoCo to get in on a developing asset class that we feel will see significant growth over the next decade.
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