- AT1 contingent convertible bonds (cocos) and preferred shares (prefs) are both hybrid securities that qualify as Tier 1 regulatory capital for banks
- Prefs and cocos rank at the same point of subordination but cocos offer a significant yield pick up
- Cocos offer the potential of an alpha rich opportunity set that lends itself to an active investment management style
- The Bluebay Financial Capital Bond strategy (FCAP) was launched to benefit from opportunities in Financial Institutions capital structures and has an investment process placed to capture the opportunity that we believe exists in cocos
- The European Banking system remains on an improving fundamental trajectory
Cocos and prefs are very similar in structure, yet cocos are often considered a new and complex asset class, leading to a degree of caution towards them from end investors. We believe this is misguided. While we would agree that focused active management is a necessity to navigate the complexities of cocos, we would highlight that they are an evolution of hybrid bank securities rather than a revolution. In particular, we compare cocos to US bank prefs, an asset class with a much broader institutional following, and argue that not only do we view cocos as being superior in structure but we believe they offer significantly greater alpha opportunities for investors underpinned by a backdrop of steadily improving credit fundamentals.
Hybrid bank securities
Hybrid bank securities in their simplest form are an evolution of prefs – instruments that combine features of debt and equity. Prefs have been in issuance since the 19th Century and hybrid bank securities since the 1990s, so they are by no means a new phenomenon.
These securities have offered advantages for both the issuing banks and investors. Banks have benefited from regulatory capital credit, rating agency credit, structurally through the rights offered to holders (e.g. no voting rights) and an alternative investor base ‒ benefits which combine to lower the cost of capital.
For investors, hybrid bank securities have the potential to offer higher yields than senior debt, fixed coupon payments as opposed to variable dividends and seniority ranking over common equity investors. Despite their junior ranking in the capital structure, we have seen that they also tend to be issued from highly rated institutions. We believe this allows investors to enhance yield by moving down the capital structure rather than the issuer rating spectrum.
One of the critical drivers of hybrid capital issuance for banks is regulation. To optimise the cost of capital, we view it as essential for banks to obtain regulatory capital credit for their hybrid securities. As banks have grown to become more global, there have been increased efforts to harmonise regulation, capital adequacy, and subsequently the structures of hybrid securities. This has been driven by the Basel Committee who formulates standards and guidelines on best practice and capital adequacy, with the rules they set then translated by the respective members of the Basel Committee into national laws. Within the standards there remains a degree of scope for individual jurisdictions to diverge, as long as the minimum requirements are met. This is often from necessity due to differing tax, insolvency laws and market structures but can also arise from differing regulatory views.
Both European and the US regulators give capital credit to their banks to issue hybrid securities for up to 1.5% of their risk-weighted assets, in line with Basel standards. While in both jurisdictions these hybrids meet the Basel standards, differences remain between the structures of securities. At first glance, cocos – the European version of hybrids ‒are more complex due to some of their inherent features. This has led to the perception that cocos are riskier, leading institutional investors to be slow in embracing the asset class. In our view this perception around increased risk is misguided and those investors willing to understand the complexities of the securities often benefit.
The table below summarises the features required in hybrid securities to receive regulatory capital credit. You can see that cocos and Prefs share the same ‘DNA’ borne out of the Basel regulations, but there are important differentiating features to be explored.
Hybrid capital under Basel III
From an investor’s perspective, there are three key structural differences between cocos and Prefs:
A dividend stopper is a clause that prevents a bank from paying a dividend to common stockholders if they do not pay the coupon on their hybrid securities. In Europe, the regulations state that hybrids cannot have dividend stoppers but they are permitted in the US. While we see dividend stoppers as the correct way to respect the capital structure, we see them as largely irrelevant as it’s difficult to envisage a situation where an institution does not have the financial means to pay a coupon to hybrid security holders but can pay a common dividend. Bear in mind that hybrids only make up approximately 10% of a banks capital base and as such coupon payments are likely to be de minimus compared with a common dividend.
Loss absorption triggers
One of the key features of cocos is that they have a pre-specified trigger point at which the instruments must have principal loss absorption. This was only a requirement of Basel III if the instruments were to be classified as liabilities for accounting purposes. As the US has taken the clear view that hybrids should be equity accounted and should not receive tax deductibility of coupons, prefs are not required by the regulations to have a trigger and there is no advantage to a US Bank in including such a feature in their instruments. In contrast, European regulators have taken the view that all hybrids require a pre-specified loss absorption trigger within the contract of the security irrespective of the accounting treatment of the securities. Further, the vast majority of European countries allow deductibility of the coupons that are paid on cocos for tax purposes.
The inclusion of a loss absorption trigger in cocos not only defines their name, but is also one of the primary reasons for investor trepidation. In Europe, the minimum trigger level, which the vast majority of countries follow, is a CET1 ratio of 5.125%, a level that we argue (and was shared by the Bundesbank in their most recent monthly bulletin) is far beyond the point of failure. In all recent cases of bank failure this is the outcome experienced, with regulators intervening well before banks have hit the minimum capital ratios and where trigger levels have or would have been exercised.
Consequently, we see this apprehension around trigger levels as being misguided as we view the key risk against which any bank hybrid (in the US or Europe) must be managed is the risk of regulatory intervention or bank failure, which would most likely come well before hitting any of the pre-specified triggers.
While not a regulatory requirement, the biggest differentiator (and mispricing) we see between cocos and prefs is the structure of the reset spread once the first call date is reached. As well as being perpetual, both cocos and prefs are required to be outstanding for a minimum of 5 years from issuance to receive capital credit. As such, on issuance the coupon is fixed until the first call date and is a function of the underlying interest rate until that call date + the credit spread. Where they differ is that cocos are generally structured to reset to a 5-year mid swap + the original credit spread. In contrast, US Bank Prefs typically reset to 3 month Libor + the original credit spread.
Illustration ‒ HSBC recently issued a USD coco with a coupon of 6.5%. This coupon can be broken down as the 10-year mid swap rate on the day of issuance + the credit spread demanded by the market reflective of the credit risk of 3.606%. After 10 years, if this bond is not called by the issuer it will reset to the 5-year mid swap rate on the call date + the original spread of 3.606%. Compare this to the most recently issued Bank of America Merrill Lynch 10-year preferred that was issued with a coupon of 5.875%. This can be broken down to the 10-year Treasury Yield at issuance + 2.931% to reflect the credit spread. In 10 years this will reset to a floating rate 3-month Libor + the credit spread of 2.931%.
This is summarised below using the current 3-month Libor rate for illustration:
In this example the HSBC coupon is 0.625% higher over the first 10 years of issuance – in our opinion, already an attractive pick up. At the first call date if both bonds are left outstanding this coupon pick up will increase further by the whatever the differential is between 3month Libor and the 5-year swap rate at that date. The average differential between 3 month Libor and the 5 year swap rate over the last 30 years is 1.5% and so taking this as the proxy, and assuming credit spreads remain unchanged, this reset structure will increase the coupon differential between the securities even more to 2.18% at the reset date, increasing the attractiveness of the HSBC coco further.
At the moment the US Treasury rate curve is extremely flat but one can observe in the above example that the future coupons expected on prefs is very dependent on where short term rates are at the call date, which is very attractive for the issuing bank. This is attractive because at the call date the coupon they pay will only be a spread over 3-month Libor. Essentially, they will stop paying any term premium to investors for the perpetual risk they are taking. Further, should spreads meaningfully tighten the instrument is callable so can be redeemed at any time under the issuers discretion and reissued at a tighter level. In contrast, as cocos generally reset to fixed rate 5-year mid swap + the original credit spread, investors in these instruments will be paid the same term premium as they did at the original issuance, meaning the call decision will be much more closely linked to credit risk rather than where the risk free rate is at that point in time.
For this reason, we view the call option the issuer holds as being more valuable in the case of prefs. Additionally, we think a significant portion of investors in both securities invest on a yield basis rather than a spread basis. In an environment with normalised sloping yield curves where investors in US Prefs potentially see the coupon they receive on their securities resetting to lower levels we anticipate many will want to exit their holdings, which could create significant price volatility in these instruments.
We do not believe investors are compensated for either of these effects, in particular, we see the value in the call option that US banks hold over their securities as much greater, leading us to view US prefs as inferior investments.
Despite our view that cocos are structurally superior due to the reset structure, we have seen that they continue to trade at a significant discount to US Prefs. The ICE BofAML Contingent Capital Index (COCO) has a current yield of 4.5% compared to 3% for the ICE BofAML Perpetual Preferred Securities Index (P0P0), offering a yield pickup of 1.5%
Assuming Treasury rate curves normalise, we think there is much greater potential for prefs to be left outstanding beyond their first call date due to the reset over 3-month Libor being higher than at issue. In addition, we continue to see the fundamentals of European banks on an improving trajectory, and the investor base active in cocos growing whereas fundamentally the improving bottom up story for US banks appear to have reached, an albeit strong, plateau. As such, we expect to see spread compression between cocos and Prefs. If spreads compress to similar levels, which we think is possible, this would imply outperformance of cocos of approximately 8%, excluding carry.
Alpha opportunity set
The US operates under one unified system of corporate, insolvency and tax law which encourages the convergence of bank models and instruments. This makes life much easier for banks and investors to navigate. Europe on the other hand is a system where there are European wide regulations and directives as an overlay on top of national insolvency, corporate and tax laws. As such, there are a wide variety of different banking models and markets and specific quirks in instruments that are necessary to meet the combination of idiosyncrasies in national laws but still be in line with European directives.
These complexities facilitate a rich environment for alpha generation potential. While we feel there is no doubt that the beta (market return) offered by US Prefs has been attractive, for the active manager, cocos offer a much wider and varied opportunity set. Comparing the dispersion of the pref and coco indices since the inception of the coco index highlights that not only have cocos historically provided higher total returns, but the dispersion between the top performers and the bottom performers has been much greater. We believe this allows for a greater opportunity for outperformance in active management.
Average of top 10% vs. Average of bottom 10% in each index
Source: ICE BAML COCO Index, ICE BAML P0P0 Index, as at 31 March 2018
The Bluebay Financial Capital Bond strategy
The Bluebay Financial Capital Bond strategy (FCAP) was launched in 2015 with the aim of capturing the opportunity set that we believe is inherent in Financial Institutions capital structures globally. In contrast with many funds that were traditionally set up to focus on prefs and are now increasing their allocations to cocos (in some cases up to 25%), FCAP has since its inception focused on the opportunity set available in European financials and cocos. The investment process of the strategy was developed with the complexities of this asset class in mind and explores not just financial factors but also overlays political, regulatory and policy analysis which we view as essential elements in successfully managing the inherent complexities of this asset class. The strategy is managed with total return in mind rather than against a specific index and has significantly performed the both the coco and preferred indices, as well as comparable bank equity indices since its inception in 2015.
BlueBay Financial Capital Bond strategy cumulative performance (NET of fees) since inception vs. coco and pref indices
Source: Bloomberg as at end of March 2018. FCAP: BlueBay Financial Capital Bond strategy, COCO: ICE BofAML Contingent Capital Index, P0P0: ICE BofAML Perpetual Preferred Securities Index. Past performance is not indicative of future results.
We are firm believers that cocos remain an asset class that offer compelling risk-adjusted returns versus US Prefs. In addition to structural differences, that in our opinion are mispriced, cocos offer notably greater potential to generate alpha through the myriad of idiosyncrasies inherent within Europe. Further, on a more macro basis we continue to observe an environment of improving underlying fundamentals in the European Banking system that we see as supportive of further spread compression.
In an effort to benefit from these opportunities we believe a strong bottom-up investment process that takes account of the idiosyncrasies of Europe, combined with an active management style is a necessity. We believe that the Bluebay Financial Capital Bond strategy is well placed to benefit from opportunities that may arise in this nascent asset class.
Download article: Bank Capital: Our case for European AT1 cocos over US preferreds
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Published May 2018