One of the lessons from the banking crisis was that before governments bail out banks in financial difficulty, equity holders and creditors should first contribute by having their investments written down. With the implementation of Basel III, European banks have started issuing new types of loss absorbing capital instruments, known as contingent convertibles or CoCos. Banks issue AT1 CoCos to meet new capital requirements while T2 CoCos are used to provide a buffer to protect senior creditors and depositors. ING Investment Management has devoted significant time to understanding the characteristics of these new instruments and assessing their investment potential.
There are two main risks with investing in AT1 CoCos. First, the possibility that coupon payments in the bonds are deferred and second, the danger that the principal amount is written down. Based on the improved capital ratios in recent years, we view coupon deferral as the primary risk.
Yields on AT1 bonds have decreased significantly in the last 12 months, driven mainly by a huge demand from yield-hungry investors. This has brought the average yield on AT1 CoCos down to around 6%. Meanwhile, the average cost of equity, the only layer of bank capital to absorb losses ahead of AT1 bonds, is about 10%. Given the “equity-like” coupon cancellation and the principal write-down risk of AT1 CoCos, ING IM believes this price differential is currently too wide.
We would assess the volatility of these instruments to be very high and that they will trade much like equity in periods of stress.
The risk profile of the T2 CoCos compared to AT1 CoCos is substantially lower as coupons payments cannot be deferred. In turn, the risk profile of T2 CoCos compared to normal T2 seems to be much greater given the automatic trigger to absorb losses. Accordingly, the 4.5% average yield for T2 CoCos, issued by Europeans banks, is significantly wider than the 2.4% average yield for normal T2 bonds. However, the new banking regulation gives authorities significant power to allocate losses to equity and creditors when resolving failing banks. Recent history shows that they will use these tools to the fullest extent against all subordinated bondholders, most importantly, to minimize cost for depositors and tax payers. They are not likely to discriminate between equally ranking T2 CoCos and normal T2 bonds.
We are currently looking at investment opportunities in T2 CoCos, based on our view that the risk profiles of T2 CoCos and normal T2 bonds are basically similar.
Caspar van Grafhorst is senior credit analyst at ING IM