CoCos in Best Returns Win European Regulatory PlauditsJohn Glover
European bank regulators, who rarely win plaudits from investors, can take credit for creating securities that produced the best returns in the region’s bond markets this year.
The riskiest debt from European banks is outperforming a gauge of 964 securities from Spain’s Abengoa SA to U.K.’s William Hill Plc, according to Bank of America Merrill Lynch indexes. The new-style contingent capital notes, or CoCos, issued to meet stiffer capital rules, returned 9.12 percent, compared with average gains of 5.86 percent for the broader high-yield bond index of companies in the region.
Policy makers created the securities in the wake of the financial crisis to ensure investors, rather than taxpayers, contribute to a bank’s rescue. The notes are known as additional Tier 1 securities and are the riskiest bank debt because they have no set maturity, have optional interest payments and can be written down or converted to shares.
“Good total returns have drawn additional capital into the sector and that’s helped move risk away from taxpayers as desired by the regulators,” Chris Whitman, head of global risk syndicate at Deutsche Bank AG in London, said in a telephone interview on June 19. “The instruments still offer attractive compensation for the real level of risk.”
Average yields on AT1 bonds fell 111 basis points, or 1.1 percentage points, this year to 5.87 percent, according to Bank of America Merrill Lynch’s High Yield Contingent Capital Index. That compares with a 69 basis-point decrease to 4.2 percent for junk bonds sold by European companies.
Banks issued about $39 billion of the capital securities this year, swelling debt outstanding to almost $50 billion, according to data compiled by Bloomberg. Societe Generale SA and Coventry Building Society issued more than $2 billion of notes in dollars and pounds last week.
Societe Generale raised $1.5 billion in its fourth sale of the securities, with notes yielding 6 percent. The Paris-based bank sold $1.25 billion in its debut issue last August to yield 8.25 percent, data compiled by Bloomberg show.
Coventry Building Society issued 400 million pounds ($680 million) of 6.375 percent notes in its first sale of AT1 debt.
Banks are bulking up on capital and re-examining their loan holdings as they prepare for stress tests and for the European Central Bank to take over as supervisor in the euro zone. That has helped persuade investors that potential losses will be limited, while interest payments of as much as the 11.5 percent from Madrid-based Banco Popular Espanol SA have lured buyers into the asset class.
While regulators are vigilant, interest rates are at record lows and banks have a ready supply of ECB cash, that may not always be the case, said Craig Veysey, head of fixed income at Sanlam Private Investments Ltd. in London, which has $10 billion of assets under management.
“These instruments are not without risk,” he said. “If the issuer’s capital levels fall for any reason, the potential for not receiving the coupon is real. And there is the danger that if you did get an isolated case of a bank getting into trouble, there would be a read-across to other issuers.”
Rising issuance and growing investor acceptance of the securities has made 2014 a year of transition for additional Tier 1 debt, according to Paul Smillie, a Singapore-based analyst at Threadneedle Asset Management Ltd., which oversees about $126 billion. That process has prompted Barclays Plc and Credit Suisse Group AG to join Bank of America in compiling indexes to track performance of the securities, further hastening acceptance, Smillie said.
“The various parts of the mosaic are falling into place,” Smillie said in a telephone interview on June 19. “The bonds are becoming more accepted. It’s becoming a much more institutional asset class and moving away from hedge funds and private banks that used to be the main buyers.”
Under European Union rules, banks can count additional Tier 1 debt equivalent to 1.5 percent of assets weighted by risk when calculating certain ratios. As long as governments agree to treat AT1s as debt rather than equity, interest payments out of pretax earnings make them cheaper to issue than stock.
“Other sectors of the bond market are not offering the type of yield that instruments in the CoCo market currently do,” said Robert Montague, a senior credit analyst at ECM Asset Management Ltd. in London. “It’s as simple as that.”