Alternative investors gain appetite for Cocos

http://www.efinancialnews.com/story/2011-01-17/alternative-investors...

Harriet Agnew
17 Jan 2011

Politicians and regulators are counting on contingent convertible bonds, or Cocos as they are affectionately termed, as a way of shoring up the global banking system. The instruments work by converting to equity when a bank is in distress. The Bank for International Settlements last week confirmed the rules for Cocos it proposed last summer and Standard & Poors has projected that banks may issue $1 trillion of Coco-style instruments in the next five to 10 years. But there is a question mark over whether there is enough investor demand to absorb this projected new issuance. Hedge funds have shown signs of interest. Algebris Investments, a financials hedge fund firm, is preparing to launch a fund to trade Cocos. Django Davidson, a partner at Algebris, said: Theres a very strong regulatory drive for Coco issuance to happen. The vast majority of Tier-1 and Tier-2 securities that count towards bank capital under Basel II will be phased out under Basel III. In order to keep total capital ratios constant, banks need to either raise common equity or issue Coco-type securities. Davidson also expects retail interest. He added: This is a heaven-sent retail opportunity, particularly with cash yielding close to zero. Cocos issued by large, systemically important banks with high equity capital ratios will be solid, high-yielding investments, he said. Davidson sees capital appreciation of up to 20% over two to three years in addition to the high-running yields. He said: Initial yields of 9% will compress to 7% over two to three years as investors become more familiar with the market. The Childrens Investment Fund Management, the activist hedge fund manager founded by Chris Hohn, which has a stake in Algebris, bought into a Lloyds TSB Coco issue with hundreds of thousands of pounds, according to a person familiar with the firm. Pimco, the largest bond investor in the world, was also said to be a big buyer of the Lloyds Coco. TCI and Pimco declined to comment. Kevin Corrigan, head of credit at Lombard Odier Investment Managers, said his firm would be open to taking advantage of Cocos as part of its unconstrained credit mandates. He said: For banks that are already well capitalised at a core equity level, this provides a new way of achieving a higher return in the debt of that bank. But other investors and those with more restricted investment mandates believe there are risks inherent in the Coco structure. Last week, the Association of British Insurers, a trade body representing some of the largest investors, wrote to Michel Barnier, European commissioner for the internal market and services, arguing Cocos could destabilise recovery by restricting banks access to financing. The worry for investors is that Cocos switch to equity at the worst possible point, triggering a

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17.01.2011 13:40

Alternative investors gain appetite for Cocos

http://www.efinancialnews.com/story/2011-01-17/alternative-investors...

death spiral. Many insurers and pension funds would become forced sellers if the Cocos were to convert from bonds into equity because their mandates restrict them from holding shares. Of course, for all of these added risks for the investor, there is a benefit in the yield they receive for holding the securities. The Lloyds issuance is currently trading with a yield of 9%. From a banks point of view, the higher the coupon, the less economical Cocos become. It may reach a point where it will be cheaper to issue new equity. Roger Doig, a credit analyst at Schroders, said he didnt think his firms fixed income or passive funds would invest in Cocos because of their equity-like characteristics. He said: When Cocos are triggered, the hierarchy of the capital structure is subverted. Your entire existence as a bondholder is predicated on the equity cushion. When the Coco is triggered, you are rendered pari passu or subordinated to an equity holder. You can be putting principal at risk without the bank having failed, which is complete anathema to bond investors. Not all Cocos will be rated precluding those that can only invest in rated bonds and those that are rated will probably be graded lower than traditional bonds issued by the same bank. Even among those with a wide investment remit, such as hedge funds, there is still some reticence because of the lack of clarity surrounding Coco issuance. Philippe Jabre, founder of Geneva-based hedge fund Jabre Capital Partners, said: We will look into investing in Cocos. The problem is that you cannot value a Coco because every time you have a meeting of regulators the definition of capital changes. It makes me uneasy about understanding what level could trigger the Cocos. So far, Switzerland is the only country whose regulator has publicly backed the use of Cocos. Antoine Loudenot, head of capital structuring at Socit Gnrale in Paris, said: Within the European Union, issuers are looking for a clear message from the national regulator or the Basel Committee/Financial Stability Board. A lack of regulatory harmony is the biggest roadblock to new issuance. Outside of Switzerland, it is uncertain where Cocos will sit in the capital structure. Banks will need to hold more of them if they are viewed as subordinated debt rather than senior debt to meet the same capital requirements. Loudenot added: From an issuer standpoint, the risk is you are doing this too early and that the criteria you are trying to achieve are changed by the regulator. Most importantly, without a defined trigger event there is a suggestion that Cocos could be triggered at the regulators discretion in case of non-viability of an institution, rather than a fixed percentage of capital conventional pricing becomes difficult, if not impossible. This could further stymie investor demand. Loudenot said there was also uncertainty surrounding the minimum size of a Coco investors potential loss needed for it to qualify as regulatory capital. Bankers said that Cocos, while conceptually appealing, remain essentially untested. Until there is greater regulatory clarity and standardisation of the structures, it is likely investor interest in Cocos will be constrained to specialist investors such as hedge funds and high net worth individuals.

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17.01.2011 13:40

Alternative investors gain appetite for Cocos

http://www.efinancialnews.com/story/2011-01-17/alternative-investors...

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