Contingent Convertible Bonds, also known as Cocos, have been popular instruments among retail investors over the past few years. However, we consider that the extension risk is underestimated by the market.
During the 2009 financial crisis, many banks faced strains on their capital. In an effort to support the financial sector and to avoid contagion to the broader economy, Governments provided support to some systemic institutions, at the expense of taxpayers. In the wake of this, regulators implemented measures to strengthen banks’ balance sheets and implement capital buffers. Contingent convertibles are instruments which address this issue. They feature a loss absorption mechanism, either through conversion to equity or principal write-down, designed to absorb losses and boost the issuer capital should it fall below a certain level. The notes generally offer a fix coupon until a call date, which generally occurs after five years. At this point the issuer has the option to call the issue, if it receives supervisory approval and that it can demonstrate that its capital position is well above the minimum requirements after the call option is exercised, or it can replace the called instrument with capital of the same or better quality, or can leave the current note in place and pay the agreed margin at the time of issue over a reference rate, usually the swap rate, until another call date, usually 5 years.
The first ever contingent convertible was issued by Lloyds, during 2009. However, a large number of contingent convertibles were issued in 2013-2014. This means that the first batch of contingent convertibles issued then are reaching their first call date. Cocos have been popular with retail investors, as their emergence coincided with a period where yields were at their lows and bondholders were looking for sources of incremental yield.
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Discussing with our clients, we get the feeling that many take the call for granted, and believe the issuer has the “moral duty” to call its issues. We, however have a different view, and think the call decision is governed by economic factors rather than “public relations” concerns.
As mentioned above an issuer facing an upcoming call date has three options; redeem the issue, replace it with a similar instrument, or leave the current issue in place and pay the determined margin, generally the issue margin agreed at the time of the issue, over the swap that matches the next call date.
Call is not guaranteed
It only makes economic sense for an issuer to call an issue if it can refinance himself at a significantly lower rate, after the costs of launching a new capital instrument are factored in. If the pre agreed refinancing margin is equivalent, or in some case lower than the market rate, we believe an issuer has no economic interest to redeem its issue, but would rather extend the issue to the next call, taking place in most cases, after another five years.
We think that one way to assess the likelihood of an issue being called is to look at the spread the issuer would have to pay should it issue a similar instrument with a 5 years call date today. We calculated the spread the issuer would have to pay today and compared it to the refinancing spread built in the exiting note.
However Financial Analysis carried out in Switzerland explains that –
The lower a security is positioned in the chart, the less economic sense it would make for its issuer to call it, and therefore the less likely it is to get called. The securities in the top portion of the chart are the ones likely to get called. Investors holding or considering investing in the bottom bracket should consider this risk factor.
Built in refinancing rate minus new issue spread