Tuesday 04 February 2014 by Justin McCarthy Education (advanced)

2014 – year of the CoCo (part 3 - demand)

As discussed in the previous editions, Basel III regulatory developments have forced a change in the way banks can structure capital securities and this has important consequences for demand, particularly from the institutional market

Key points:

  1. Despite predictions of a contingent convertible capital securities (CoCo) market as large as €240bn, demand is anticipated to keep up with supply
  2. Initial demand came from the private/high net worth market, but recent structural developments have seen an increase in institutional participation
  3. Significant issuance in 2014 (and beyond) is still expected to create attractive entry points and we have already seen a number of issues in Asia, including the recent Bendigo and Adelaide Bank subordinated bond

To summarise the first two articles, CoCos are the new form of hybrid regulatory capital security issued under Basel III, replacing the old style step up Tier 2 subordinated debt and Tier 1 securities. While issuance to date totals around €35bn, the market is predicted to increase exponentially with forecasts of global issuance up to €240bn. Please click Part 1 and Part 2 to read earlier articles.

With predictions of significant issuance in a relatively short timeframe, the big question is who is going to buy the securities?

This edition looks at demand for CoCos.

Demand

As discussed in the previous editions, Basel III regulatory developments have forced a change in the way banks can structure capital securities and this has important consequences for demand, particularly from the institutional market.

To date there has been approximately €35bn of CoCo issuance. Reports from the more recent issues suggest that order books have been three to four times oversubscribed in many cases, suggesting very strong demand.

Interestingly, despite the vast majority of issuance coming from European banks, most of the issuance has been in USD. This is especially the case for Tier 1 CoCos. Tier 2 (dated subordinated debt) CoCo issues have been roughly 50% in USD and 50% in €.

The reason is much of the early demand came from private client/high net worth (HNW) individuals attracted by the high coupon rates of 7 – 9% (against a backdrop of very low outright interest rates). In particular, most of the initial demand has come out of Asia where USD is the preferred currency for HNW investors.

The more traditional institutional market had been relatively slow in showing demand, mainly due to the technical implications of what may occur in the unlikely event a conversion to equity is triggered. Mandate restrictions prevent many institutions and funds from owning shares, at least in their fixed income portfolios. As many of the CoCos issued to date are converted to equity if a non-viability or pre-set trigger event (typically Core Equity Tier 1 or CET1 ratio falls below 5.125%) occurs, these entities cannot hold CoCos as it could breach their mandate.

However, two recent developments have seen an increase in institutional demand.

The first is a very simple one. Rather than convert to equity, CoCos are increasingly being structured so that they are simply written down or off if the non-viability or pre-set trigger event occurs. While this is clearly an inferior structure, it does allow the institutions to tick the box that their portfolio will not hold equities. (However, we would argue that in practice if a trigger event occurs, there is likely to be little difference between the capital loss on conversion to equity and write-down/write-off, but this will be discussed in greater detail in coming weeks).

Moreover, to be included in the widely followed Bank of America Merrill Lynch High Yield Index a bond cannot be converted into equity and structuring CoCos with straight write-off or write-down mechanisms has allowed greater demand from professional managers that follow this index. For the more technical reader, this has seen an increase in Rule 144A issuance (as opposed to Reg S) and hence a stronger “bid” from the US “insto” market.

The second development is also aimed at increasing institutional demand. Many new issues have an automatic share sale facility that will buy shares from CoCo holders immediately upon a conversion event. The new feature means institutions are again able to meet the test of not holding shares. This has also allowed further issuance of CoCos that are convertible to equity, as opposed to the straight write-down/write-off structure detailed above.

Many of the recent local issues, including the ASX listed subordinated debt and hybrids by the major banks and Suncorp (all technically CoCos), as well as the recent Bendigo and Adelaide Bank over the counter (OTC) subordinated bond that we have written about over the last two weeks ("Bendigo and Adelaide Bank subordinated debt issue""Bendigo and Adelaide sub-debt proving popular - now available to retail investors"), have included this share sale facility and hence increased institutional take-up.

Conclusion

While the raw numbers for the potential size of the global CoCo market look huge with estimates as high as €240bn in issuance (supply) over the coming years, the development of structures that meet institutional mandate rules is a key support to demand.

Approximately €140bn of “old style” step up Tier 1 securities are expected to be called in coming years and it is anticipated that much of this will be replaced by the new style CoCos. Institutions are the major holders of the “old style” regulatory securities and market developments in structuring, such as the two detailed above, will ensure that institutions continue to take the lions’ share.

However, important demand from yield hungry private client/HNW investors is adding materially to the demand side of the equation, not only in Asia but across the developed world as well. This was also the case in the recent Bendigo and Adelaide Bank subordinated bond issue which had both strong institutional and private demand.

We expect the local market to further develop in coming months and indications are a number of domestic banks may issue CoCos in the near future. It is expected that the preferred avenue for Tier 1 hybrids/CoCos will continue to be the retail dominated ASX listed market while an increasing number of Tier 2 subordinated debt bonds may find their way into the OTC market following the success of the recent Bendigo and Adelaide Bank issue.

While we believe there is a growing pool of demand in the global market, significant issuance in 2014 (and beyond) is expected to create attractive entry points in periods when supply outstrips demand. It remains to be seen but this may occur earlier than first thought in Australia based on recent press reports and discussions.

In coming weeks we will delve into the structural features of CoCos and compare them to “old style” regulatory securities and conclude the series with our top CoCo picks.

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