The New Love for Chinese Yield Chasers: Leveraged Coco Bonds

  • Yuan's decline fueling interest in notes linked to cocos
  • Three-year note linked to China bank bonds pays 12.2%

The Chinese yuan’s declines and lower local rates have encouraged the nation’s investors to go offshore in their quest for yield. That’s fueling more interest in leveraged notes linked to contingent convertible bonds issued by Chinese banks.

“In recent months, we have seen growing interest from onshore Chinese clients in offshore U.S. dollar-denominated assets,” said Deng Xixi, head of the financial products department at Haitong International Securities Group Ltd. “A lot more Chinese clients are shifting their focus from the Chinese stock market to cross asset solutions, especially China bank preferred share products with leverage features to enhance yield.”

Chinese lenders are the biggest issuers of such capital used to meet rules for lenders to have sufficient buffers to cover losses. The convertible preferred shares are sometimes called coco bonds. Leverage features allow investors to gain more exposure to the underlying assets, or coco note in this case, than they had paid for.

Leverage Boost

Strong demand from investors has driven the yield on coco bonds down but with leverage, the return is still very attractive, according to Ryan Chan, the co-head of business development at Societe Generale SA’s cross-structuring group for Asia excluding Japan.

“Leverage is the theme for clients in the Greater China region and we have seen a lot of leverage requests on coco bonds,” Hong Kong-based Chan said. “The leverage can go from a bit more than one to up to three times.”

A three-year note sold last month by special purpose vehicle ELM BV linked to a portfolio of coco bonds including those from Bank of China Ltd. and Industrial and Commercial Bank of China Ltd. The deal, arranged by UBS AG, pays a 12.2 percent annualized coupon, data compiled by Bloomberg show.

Banks have been changing how they offer the product to suit shifting investor needs. The latest trend is to add an active management component to a portfolio of such bonds, according to Cyrille Troublaiewitch, head of Citigroup Inc.’s multi-asset group for Asia Pacific.

“The portfolio can be managed by investors directly or by a specialized manager,” Troublaiewitch said. “This is a way to get access to a more diversified portfolio while benefiting from some active re-balancing of the portfolio.”

Unlike other asset classes, the performance of coco bonds, which can convert into equity when certain capital ratio conditions are triggered, has been either one way up or stable even in recent volatile markets, according to Societe Generale’s Chan. But the ability for investors to analyze the likelihood of a trigger event, where the debt will convert to equity at an “unfavorable” price, is a key aspect, he said.

“Coco bonds have existed since 2009, so globally, it’s not new,” Chan said. “But since the emergence, we haven’t gone into another period of financial crisis. We’re not exactly sure how this instrument is going to perform when conditions change.”

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