What makes CoCos a reliable source of returns during periods of market volatility?
Within the fixed income universe, Financial CoCos offer high coupons/yields compared to most fixed income products/sectors with a relatively short average duration and also generally better ratings than high yield corporate bonds. Therefore, in times of rate volatility, for example, high carry and low rate sensitivity can provide a cushion to absorb market shocks. The fundamental resilience of the EU banking sector makes these instruments particularly attractive since they are issued by large, highly profitable banking groups with large capital buffers to protect against downside risks.
What role can CoCos play in a balanced portfolio?
CoCos are bonds issued by financial institutions mainly across Europe. They offer exposure to a much improved banking sector offering attractive income and potential for capital appreciation with much lower volatility than bank equity. Therefore, they can be a valuable component of a balanced portfolio by providing stable income (high coupons) and significantly lower risk than equity investments. CoCos can also provide diversification benefits to a traditional Investment Grade bond allocation or riskier exposure to HY corporate bonds in a balanced portfolio.
What potential risks should investors consider with CoCos?
The main risks for a CoCo investor are “trigger risk”, “coupon cancellation” and “extension risk”. Trigger risk refers to the potential conversion of CoCos into equity or full/partial write-down if specific equity ratio thresholds are breached. These capital triggers are however very far apart and a bank with a capital ratio below the trigger level would most likely already be in resolution (default) with wider implication also for more senior debt securities. Coupon cancellation is a more realistic risk that requires in-depth analysis of bank-specific fundamentals and capital buffers. However, it is important to note that banks have so far always paid CoCo coupons, even throughout the Covid crisis and after the Russian-Ukrainian war, when they had to cancel stock dividends in 2020 for example and at other times in the past. Finally, extension risk refers to the possibility that a CoCo will remain outstanding after the first redemption date. This risk can be managed by carefully evaluating the bonds at the most likely call date without assuming that they will all be called at the first opportunity. These three risks can be well managed with careful fundamental analysis and an active approach to investing in this asset class.
the Asia Fund Selector Philippines Investment Forum took place on May 12, 2022 and was sponsored by Janus Henderson Investors, Jupiter Asset Management, Pimco and TT International.
Learn more about what was discussed and the strategies that were presented here: https://fundselectorasia.com/events/fsa-investment-philippines/