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Are CoCos a risk too far?

CoCos have come under the regulatory spotlight after the FCA took action to limit their distribution to individual investors. But while no restrictions have been applied to retail funds, some managers warn that CoCos could be a risk too far even for them.

Contingent convertible securities are a type of bond that is automatically converted to shares if a certain level is breached, often within a certain timeframe. This could be, for example, when a bank’s capital ratio falls below a pre-set minimum level.

CoCos have proved popular as the search for income and yield continues thanks to the higher yields on offer in exchange for the additional risk involved with a possible conversion. 

However, the sector has shown signs of a sell-off in recent weeks, with prices falling while yields have spiked.

In its first use of new consumer protection powers, the FCA has temporarily restricted the retail distribution of CoCos to individual investors, describing them as “complex” and “highly risky”.

FCA director of policy, risk and research Christopher Woolard warned that investors might be drawn in by the “high headline returns” available through CoCos but might find coupon payments “extremely difficult” to properly assess because of the transition from debt to equity.

The FCA has opted to continue allowing what it describes as “experienced investors” access to CoCos and the restrictions do not apply to retail funds.

However, some bond fund managers and advisers have raised concerns about the risks involved in investing in CoCos and some are avoiding the sector entirely.

For JP Morgan Asset Management bond fund manager Anthony Valle it is the high level of unpredictability in what could spark a fall in a bank’s capital ratio that has led him to avoid investing.

He says: “CoCos are different from convertibles because you would invest in convertibles expecting that the company will do well. By contrast, when you buy a CoCo, the coupon may be higher but you have to pray every day that nothing is going to go wrong.

“So they are very different types of product and the issue with CoCos is you don’t know what could trigger this negative event.”

Recently, Valle has considered building some exposure to CoCos through his JPM Global Convertibles Income investment trust – given the opportunity for income and yield – but he remains cautious on the asset overall.

“If we think a company looks stable and there is very low risk of a trigger event, it could make sense to invest in CoCos because it would generate an income,” he says.

“But this is only theoretical because we have not bought any and I don’t think the level of compensation we are seeing at the moment is right for the risk. They have not proved to be a bad product so far but  the risk is still quite high.”

The fixed income managers behind the £720.1m Kames Capital Strategic Bond fund have long questioned levels of exposure to hybrid bonds such as CoCos because of their “equity-like” behaviour, according to support manager Colin Finlayson.He argues the bonds “should not be a core part of anyone’s fixed income exposure”.

He says: “Within a fixed income fund context, some of these CoCos start to stray a bit too close to being equity-like and there are dangers within that. Clearly, if the market is doing well then they make money and the fund will perform.

“But, for us, we would have to be very selective about what exposure we would take because we don’t think it is something that should be a core part of anyone’s fixed income allocation. 

“We are very clear that we would never say ‘never’ to investing in these assets, but we have also been very dogmatic that we have fixed income funds that buy fixed
income assets.”

The need to be selective when it comes to investing in CoCos is also crucial for the fixed income team at Alliance Trust Investments, according to bond manager Dan Daldry.

“We are very selective in terms of what we buy,” he says. “CoCos are without a doubt the highest risk investments you can make in the bond market, setting high yield to one side.

“You really need to understand the quality of the issuer and the structure of the CoCo. You also need to be very careful about the level of volatility that you expose yourself to in the fund.”

The £318.8m ATI Monthly Income Bond fund currently has about 5 per cent in CoCos but exposure is unlikely to rise above this level, with the managers strongly favouring what Daldry describes as “lower risk” retail and commercial banks such as Lloyds while avoiding “highly leveraged risky investment banks like Deutsche Bank”.

Whitechurch Securities head of research Ben Willis acknowledges the risks involved with CoCos but argues that experienced bond managers should be able to make the right calls and know their limits.

He says: “We clearly question managers about their exposure to CoCos when we meet with them, as we would any other part of their portfolio, but in terms of the strategic bond managers we’re invested with, we have used them for a very long time so we are comfortable enough to trust them to make those tricky decisions and pick up on value in bond markets.”

Cocos

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