21st January 2019

CoCo pops up | Bank Capital Insights

CoCo index is up 3% YTD.. and it is just 20 days in the new year

So, AT1 bonds have generically rallied 3 points or so but some bonds are up 4-5 points in a very short period and given the cash prices (low to mid 80s) it translates to a 5% return.   All this in the first 3 weeks of this year and almost half the returns (10%) I had penciled in this for the entire year.

Why did CoCos pop? In a nutshell the performance was driven by re-assessment of rates…..

better than expected earnings from US banks and mouth watering yields on USD paper issued by fundamentally strong names.  And add to that, the old chestnut – the lack of supply, but also real money folks have cash to put to work leading to inevitable short covering.

Will it hold / is there more upside to come?

And I don’t any reason why it would not hold for now.  But, clearly single name selection becomes key and owning the right instrument becomes even more crucial.  Owning AT1 paper issued by high quality issuers like HSBC, ING, Lloyds, Nordea, Rabobank and UBS should provide safety until ‘all clear’ signals emerge.

It feels like the hurricane season and they keep coming, while for credit markets there a quite a few storms to pass by – Brexit, Trade war resolution, Fed/ECB policy action, growth slowdown, disinflation and financial conditions tightening etc.

Given this background, further significant upside performance on a directional basis seems unlikely and hence it seems setting up relative value trades the better strategy.  I would recommend long AT1 paper in the defensive names which can hold up well and short the names which are exposed to many of the tail risks out there. Also, owning AT1 risk and owning protection in other parts of the credit markets makes sense – for example own bonds giving 7%+ yields and hedge with the liquid credit indices especially US HY.

Is AT1 a pure high beta play with stinging tail risks?

The short answer to that is YES.   But, with careful risk management/mitigation, AT1 bonds can deliver high risk adjusted returns (or what I call ALPHA).   What is required is a deep understanding of the interplay between the equity and sub debt within the capital structure of an issuer and a good grasp of macro-economic events and a huge judgement call on rates.  If an investor is able to master the subordination risk premium that is needed for a given issuer, they are sure to outperform the market.  The problem seems to be the that the AT1 market has too many tourists who are lured by the high yield and then get stung by the tail risks.

How to value this beast?

What is the single most driver of AT1 valuation – equity metrics, duration, spread premium for inherent credit risks, risk premium for the varied options sold to issuer – coupon deferral, non-call, and potential trigger risks for conversion / writedown?

Whilst the right answer is a combination of all of the above factors (and hence very difficult for ordinary folks to decipher) the real and more important answer seems to be liquidity risks (i.e. finding a clearing level) in terms of finding new buyers. This is especially when markets are focussed on a particular macro tail risk event (say Italian politics or EM contagion) and/or headline risk on the issuer and the above mentioned valuation metrics are thrown out of the window.


Whist CoCos have popped-up and provided some with a huge sugar rush, one needs to be cognisant of the underlaying risks that this instrument exposes and the potential for stinging pain.  

Hence, we reiterate the message that single name selection and within that the right bond to own is absolutely crucial – when in doubt, ask the specialist/expert.  And hopefully, by now, you know where to find the expert…..

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GJ Prasad

A senior European bank research specialist with significant breadth/in-depth sector knowledge, GJ has researched bank capital instruments extensively - having covered the asset class for more than 15 years as an analyst and 7 years as a risk taker in buy-side roles. His specialisation includes carrying out detailed financial modelling work on the European banks focusing on asset quality, earnings and capital adequacy metrics. His deep-dive work focuses on single name selection and extensive risk analysis on capital securities, especially on structural features, issuer credit profile and equity/AT1 valuation.