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There have now been three successful issues by banks in Europe of a new type of investment – the contingent convertible (CoCo).
Since each CoCo issue was for several billion dollars, and European banking authorities want banks to carry a lot of their capital in this form, we should expect issues over here pretty soon. Those who know my cynical attitude towards banking innovation will be surprised to hear me say this, but actually they're a good idea for banks.
Forward-looking investors should make sure to keep this new security on their radar screen: CoCos could prove to be a decent deal for investors, provided that you pick the right bank to invest in.
CoCo Bond Basics
A contingent convertible bond, or CoCo, pays a fixed interest rate and gives the investor the right to exchange the bond for equity at a fixed price.
If you're the CoCo holder, that's a big advantage to you:
- If the shares don't go up, you have a fixed-rate bond and are repaid at maturity.
- If the shares do go up, you can convert your bond into stock and can take advantage of most of the share-price increase.
A contingent convertible bond is structured like a regular convertible, except that the conversion into equity happens only if the capital ratio of the bank issuing it falls below a given predetermined level (this is usually calculated by the bank's regulator).
From the point of view of the bank that issues this security, this is attractive because it tops up the issuer's capital automatically when his loan portfolio or derivatives games go wrong.
Instead of the bank having to be bailed out by the government when it makes huge losses, it bails itself out by getting a new injection of capital from conversion of the CoCos. And when the bank isn't in trouble, it accounts for the CoCos as debt, pays only a moderate interest rate on them (tax-deductible in most places) and doesn't dilute its earnings.
For us as investors, the virtues of the contingent convertible bonds depend on two of the issuing bank's key attributes:
- How solid it is as a financial institution.
- And what type of business it does.
During the 2006-07 financial boom that preceded the crash and subsequent financial crisis, The Bear Stearns Cos., Lehman Bros. Holdings Inc. (PINK: LEHMQ) and Countrywide Financial Corp. could doubtless have issued contingent convertible bonds.
These CoCos would have been very bad investments, because when trouble hit they would have converted into the equity of a financial institution that was still in deep trouble, with huge amounts of risky assets on its balance sheet.
The First CoCos Emerge
The first CoCos issued – for Lloyds Banking Group (NYSE ADR: LYG) in December 2009 – suffered from this problem. These securities were convertible into equity of Lloyds if or when the regulator declared that Lloyds' Tier 1 capital ratio (essentially the ratio of real share capital to total assets) had fallen below 5%.
The bonds were issued in an exchange for Lloyds subordinated debt. In my view, even the interest-rate boost of 1.5% to 3% that investors were given on the CoCos that they received in exchange for that debt failed to make them a good investment.
Having foolishly bought the near-bankrupt-mortgage-lender HBOS PLC at the peak of the global financial crisis, Lloyds' balance sheet was full of rubbish. And that meant that the odds of a "forced conversion" were quite high.
It hasn't happened, yet.
But the Lloyds CoCos remain vulnerable to a further downturn in the British housing market, which could well take place as global interest rates rise (London house prices, in particular, are still in nosebleed territory).
However, the two CoCos bond issues already completed this year – each of them $2 billion issues that were made directly in the open bond market – are much more solid propositions. The first was for Rabobank Group, one of very few banks in the world still rated AAA. The snag was that Rabobank is mutually owned, so there are no shares to convert into. Instead, the bonds were automatically written down to 25% of their value, if Rabobank's Tier 1 capital fell below 7%. In return, Rabobank paid an interest coupon of 8.375% – very juicy indeed for a bond from a AAA-rated bank.
The second issue, which came out in February, was a $2 billion issue from the Swiss bank Credit Suisse Group AG (NYSE ADR: CS). Again, the Tier 1 conversion trigger (for conversion into shares in this case) was set at 7% of assets, and this time the coupon was a slightly lower 7.875%.
Conversion into shares of a good bank makes this a more attractive deal than the Rabobank offering, since – as we've seen of U.S. banks since 2008 – there is a good chance of the share price recovering after a crash.
I like both issues. Rabobank is a very solid outfit, with un-aggressive management and only modest derivatives and investment-banking operations. Credit Suisse is the best of the Swiss banks, with a high-quality investment-banking operation, a huge domestic Swiss business and tight-and-capable regulation.
There's a third issue – which has been announced but not actually issued – that I don't like at all. This latest CoCo is from the Bank of Cyprus, and is for about $1.87 billion (1.34 billion euros). It includes a regular conversion option on top of the contingent one. However, the risks of banking on that island are such that I wouldn't venture into this security.
Just yesterday (Monday), Duemme SGR, a unit of Mediobanca SpA (PINK ADR: MDIBY), and London-based hedge fund Algebris Investments LLP announced the launch of a new fund that will specialize in investing in convertible bank bonds.
As its name implies, the Duemme CoCo Credit Fund will specialize in contingent convertible bonds. Duemme, a unit of Banca Esperia SpA (in which Mediobanca has a 50% stake) and Algebris said they decided to start the fund after determining that they had a specialized understanding of this emerging asset class – a fact that could enable the fund to generate higher returns than rivals.
Davide Serra, a founding partner of Algebris Investments – and the former head of equity research for European banks at Morgan Stanley (NYSE: MS) – said in a research note that more than $1 trillion (1.4 billion euros) in CoCo bonds will be issued by banks in the next few years as they respond to new Basel III regulatory requirements on liquidity and capital adequacy.
The Move to America
Assuming that U.S. regulators find the CoCos idea attractive, as they appear to, you can expect to see some issues here in this country. Although a lot will depend on the interest rate and the quality of the issuer, some of these contingent convertible bonds could be quite attractive as investments.
Heed this one caveat, however: The first issuer will almost certainly be someone like Citigroup Inc. (NYSE: C), aggressive and poorly capitalized. That is exactly the type of bank you should avoid. Its business mix, aggressiveness and a "too-big-to-fail" status means it is quite likely to get in trouble and force its CoCos to convert.
Goldman Sachs Group Inc. (NYSE: GS) – regardless of how wonderfully profitable it is in most years – should also be avoided for precisely the same reasons.
The ideal CoCos issuer is a regional bank, too small to be considered "too big to fail," but big enough (with a broad regional base) so that it isn't over-dependent on overpriced real estate markets in California, Florida, Washington, New York City, or New England.
With only modest investment-banking and derivative operations, and a spread of mortgage loans across several states in non-overpriced areas, these are ideal issuers. At present levels, you should look for at least an 8% interest rate. That's about 400 basis points (four percentage points) above long-term U.S. Treasury bond yields, but if that's offered, it's a good deal.
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News and Related Story Links:
- Money Morning Special Report:
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Contingent Convertible (CoCo).
- The Wall Street Journal:
Mediobanca Launches Convertible Bank-Bond Fund
Tier I Capital Ratio.
- Bloomberg News:
Lloyds Banking Posts First Profit Since HBOS Purchase.
Bank of Cyprus eyes enhanced Cocos issue.
- Bloomberg News:
Algebris Plans Hedge Funds Betting on Banks' CoCos Debt, Emerging Markets.
- Money Morning News Archive:
Columns by Martin Hutchinson.