CoCos and triggers

4 min read

After several years of high returns, and with bond yields world-wide at very low levels, what is our outlook for 2014?

It may come as a surprise to many, but we still expect relatively good returns in the financial institutions credit sector, essentially for two reasons – financial companies are still strengthening balance sheets and the need to issue new higher yielding hybrid instruments driven by new regulations.

Firstly, let us take a quick look at estimates of issuance of subordinated debt. There are several factors that can drive banks and insurers to issue new subordinated debt. The top 24 European banks may need to issue as much as €630bn subordinated debt over the next five years or so to meet their “bail-in debt” requirement of 8% with subordinated debt.

Some banks such as Barclays have explicitly stated their desire to keep senior debt outside the 8% bail-in debt buffer to keep senior spreads low.

Looking at investment bank research analysts’ reports, Citigroup recently estimated that the bank hybrid sector comprising European and US issuers would grow to US$1trn over the next 5-10 years.

We feel the stars are aligned for a strong 2014 for financials credit, particularly in comparison to other fixed-income sectors.

JP Morgan analysts estimated that European banks would need to issue €280bn split as follows: €75bn Additional Tier 1 (AT1) to meet capital and/or leverage ratio requirements; and €205bn of Tier 2 debt to meet bail-in debt requirements not met by AT1 issuance.

Wide Variety

What type of instruments could be issued? A wide variety, as is already apparent from the issuance so far. Banks have issued CoCos with underlying Tier 2 structure, some with a high trigger and some with a low trigger. In the low probability event of hitting the trigger, some CoCos are written off, while others convert into equity. Similarly, AT1 issuance has been in a variety of forms – high and low triggers, and equity conversion or partial writedown (with potential future write-up) upon hitting the trigger.

The probability of hitting the trigger also varies widely – low probability in the case of Credit Suisse and UBS low trigger CoCos and the Rabobank AT1, to somewhat higher (but still low) probability with Credit Suisse, KBC and Barclays high-trigger CoCos.

The probability of a coupon non-payment also varies widely across issuers, among the small group of four rated AT1 issuers so far - with Rabobank at the lower probability end and Barclays at the higher probability end due to higher PRA buffer requirements.

What about credit quality? As we have seen in the Q3 results season, across the board European financial institutions are strengthening balance sheets – raising equity, selling or running off non-core assets, reducing higher risk activities, and improving liquidity. The upcoming ECB Asset Quality Review and Balance Sheet Stress Test are likely to strengthen investors’ confidence in European banks.

So we have a sector which is improving in credit quality, and is likely to issue a large amount of subordinated debt using a variety of instruments in 2014 and beyond. As these instruments remain still somewhat new, the yields available to specialist investors are high and substantially more attractive than almost all other fixed income sectors. For example, several new Tier 1 instruments yield around 7%, and CoCos yield around 5.7%, which compares favourably with likely high yield corporate credit returns (JP Morgan estimate 3.4% for 2014 for European High yield while UBS estimates 3.8%).

In summary, we feel the stars are aligned for a strong 2014 for financials credit, particularly in comparison to other fixed-income sectors.

Satish Pulle