CoCos: from the scare of 2023 to even being “a good idea” in the portfolio in 2024

CoCos: from the scare of 2023 to even being “a good idea” in the portfolio in 2024
CoCos: from the scare of 2023 to even being “a good idea” in the portfolio in 2024

From outlaws to a possibility. From being exiled, to gradually appearing in the portfolios of managers. In just over a year, AT1 bonds, also known as CoCos, have returned to normal, and are bringing joy to the subordinated debt portfolios of those institutional investors who endured the downpour those fateful weeks.

It should be remembered that this type of debt is a fixed income instrument issued mainly by banks to raise capital. They are issued in perpetuity, with no set expiration, and if no problem occurs, the investor (an institutional investor) receives a coupon.

The peculiarity of these AT1 type bonds is that they can be converted into shares when a bank has a solvency problem, to reinforce its capital. Hence, they are the first in the line of battle when a bank gets into trouble, the most risky. And hence, they have such high returns when these problems do not occur and that they correlate so much with variable income, since they are just that, convertible, as their name indicates.

“When equity suffers, this also suffers. You have to keep in mind that This is not a conservative instrument. It is the most aggressive within fixed income. You cannot think that you are going to get 400 points of spread without problems along the way, it is normal. That is part of the risk you assume,” Manuel Rodríguez, fixed-income fund selector at Abante, comments to Finect. “Subordinated debt does pay you, but it has a much larger beta with the equity market, and when equities suffer, because AT1 is a more volatile asset,” he adds.

From the scare of 2023…

Last year, the CoCos market was marked by an event that shook the fixed income markets for a few days: the redemption of Credit Suisse’s AT1 instruments, a measure taken by the Swiss Financial Supervisory Authority (FINMA) on December 19. March 2023, in the context of the rescue of this bank by UBS.

The outlook was already uneasy after the various bankruptcies that affected some American regional banks, such as Silvergate Bank or Silicon Valley Bank, among others. The fear generated by losses in their investment portfolios led clients to withdraw their deposits and certain entities to demonstrate their lack of liquidity.

But The collapse of Credit Suisse triggered a dramatic rise in the risk premiums associated with this type of asset, which are the first to assume losses in the event of bankruptcy or liquidation, as happened with the Swiss bank. This event triggered strong volatility in the CoCos market, wiping out approximately 7% of its volume.

At that point, panic spread among investors, who abandoned banks’ contingent convertible bonds. This caused an increase in the return required by these bonds, which went from less than 7% to more than 15% in a matter of days.

…a chance in 2024?

However, moving forward to 2024, the picture appears to have changed dramatically for many fixed income investors. Luca Evangelisti of Jupiter AM highlights in a recent analysis that the CoCo market has stabilized: “investor confidence has returned and the new crop of AT1 issued in recent months has the potential to generate high returns.”

Evangelisti also notes that despite a restrictive interest rate policy and geopolitical uncertainty, “CoCo prices already largely discount downside risk, making their future valuations quite attractive.”

The CoCos market has recovered from the fall of 2023. For example, this graph of the Invesco AT1 Capital Bond ETF, an exchange-traded fund that invests in this type of subordinated debt.

On the other hand, Fidelity International in their latest fixed income report comments that they are now neutral with the asset: “After their ‘beta rally’, we see little room for them to tighten considerably, but we still like AT1s with amortizations upcoming advances,” they highlight.

“AT1s have been the best performing asset class in credit markets since the beginning of the year, with a total return of around 3%, well ahead of high yield and even senior bonds,” he comments. Elisa Belgacem, senior credit strategist at Generali AM.

The expert adds that the primary market for CoCos “has been gradually reopening during 2023” and points out three main reasons why AT1s are still “a good idea” to invest in: better banking fundamentals than other non-financial high yield companies with similar credit ratings; very limited net supply and greater resilience compared to other high yield segments.

For his part, Rodríguez de Abante highlights the normalization of the market regarding these AT1s, which has contributed to seeing large banks such as BBVA or UniCredit carrying out new issues of CoCos. “The investor has been there, the emissions have been covered.”

“Our feeling is that everything has normalized quite a bit, the perception of risk has normalized, but there were a few months in which everything was quite closed. There were outflows, There were market agents thinking about a coupon and not about the fact that if there is a solvency problem, the subordinated debt layer has to respond” remember.

Are they a fixed income instrument that can be used as an opportunity in 2024? “For an aggressive fixed income investor, as an alternative to equity, we do not see it as nonsensebeyond the fact that the spread has increased a lot, because the market has normalized a lot,” says Rodríguez.

The Abante selector comments that the manager has been reducing the weight of the CoCos in the portfolio. “We have some AT1, but we have been reducing the weight in the portfolio because the market has run a lot. The spreads have not stopped narrowing and tactically we have been reducing in case there were any setbacks. It is not bad, but now they do not compensate as much,” concludes.

This content has been prepared under editorial criteria and does not constitute a recommendation or investment proposal. Investment contains risks. Past returns are no guarantee of future returns.

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