Following the challenges of 2018, we examine the opportunity set in the contingent convertible bond (CoCo) asset class.
With CoCos remaining mispriced in the bank capital structure and rising dispersion likely to boost alpha generation, we see upside potential for the asset class should the current pause in monetary policy return us to the ‘goldilocks’ credit markets of 2017.
Undeniably, the world is in a less certain place than a year ago. Trade disputes continue to rage, the path of rates is uncertain, European QT is occurring concurrently with slowing growth and Brexit highlights the global trend of populist inward-looking policies.
But we are not yet in the camp that global recession is imminent; the US economy remains fundamentally strong and we are seeing broad-based growth within Europe.
Our base case scenario:
- Weak but still positive growth
- Volatility to remain high
- Relative valuations continue to look very attractive to us
- Bank fundamentals remain extremely strong and are mispriced
- Returns for CoCos are likely to be in line with the carry of the asset class of approximately 7%.
Significant balance sheet strengthening, combined with limited earnings momentum, is a cornerstone of our view that if you want to invest in European banks; CoCos – not equity – remains the sweet spot.
European banks – attractive valuations
Source: Bloomberg, BlueBay Asset Management, 31 January 2019
How we will invest in 2019
We expect dispersion to revert to what we normally see in the asset class. We will continue to take concentrated, conviction views and strongly believe that this is the most effective way to generate alpha over the medium term.
Undoubtedly, we expect 2019 to be characterised by increased volatility. We can plausibly paint both a bull and bear picture for risk assets, but our greatest confidence is that there is less directional certainty.
This warrants taking an increased degree of caution, but still focussing on the most mispriced parts of the capital structure and where we see arbitrage opportunities.
While the outlook for risk assets is more uncertain, our conviction view on CoCos remains strong.
Price action at times may be volatile but we believe fundamentals will prevail and we remain convinced that when the credit cycle does turn banks will outperform.
Our latest white paper provides a deeper dive into our outlook for CoCos and how we plan to invest in 2019.