Friday, 20 July 2018

Wake me up before you CoCo

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SwissInvest strategist Anthony Peters says contingent convertible bonds defy the rules of lending

Anthony Peters, SwissInvest Strategist

I’M NOT SURE that it’s safe to leave the house without being bombarded with material concerning the latest Contingent Convertible offering.

When the first ones from Credit Suisse and UBS pitched up a couple of years ago, they were very nearly laughed off the park and now, to quote my esteemed colleague Keith Mullin’s words, CoCos are threatening to find themselves rated as an asset class in their own right as €100bn of issuance prepares to come shooting down the pipeline.

CoCos are evidently all the rage at the moment and as issuance increases so will the push by investment managers to be able to take the high-yielding product into their portfolios, lest they end up underperforming those members of their peer group who can.

I would not purport to be a specialist on the subject but if I see a bond with an embedded total loss feature, I balk.

Not only that, but the last time we saw yield-starved investors being sucked into an asset class with an otherwise unmatchable return profile, we ended in the mother and father of credit crises – think sub-prime mortgages.

Looking at the liability side of the balance sheet, a line item that usually appears at the bottom is of course common equity. However, looking at some of the recent CoCo issuance – the Swiss Re deal springs to mind – I am left wondering whether it might not belong in that place. In trying to find a way of bringing subordinated debt holders into the process of loss absorption, the authorities have unwittingly created a monster that brings with it neither the advantages that lenders are supposed to enjoy nor those accruing to equity investors.

BACK IN THE 1980s I had a girlfriend whose father had been very successful in business. In those days, being a name at Lloyd’s was all the rage and I asked him whether he too was involved. He answered with beautiful logic that every risk has a price but how, he wondered, does one price the risk of unlimited liability? When asbestos claims began to hit naive Lloyd’s names and large swathes of the English upper middle class suddenly found themselves, well, on their uppers, I finally understood what he had meant.

CoCos permit the commission of every cardinal sin of debt markets. In effect, as opposed to classic hybrid debt, the borrower can default without defaulting. This is a risk that cannot be modelled and that cannot therefore be priced. Of course, we will be told that the market, once sufficiently deep, will find the equilibrium price for the asset class – I suppose according to the same fail-safe rules that it previously applied to pricing sub-prime mortgage risk.

With 10-year Bunds at 1.5% and 10-year Treasuries at 2%, who is going to argue with a 7% coupon?

Going back 10 years, the single most significant problem ahead of all others that drove us into the credit crisis was the search for yield and, not to be underestimated, the competition by financial institutions not to underperform the opposition. It is amazing how markets can talk themselves into rationalising the irrational, so long as the returns look to be “superior”.

As with most exotic products – and I rate CoCos as being highly exotic – the early entrants will probably make out like bandits but as issuance increases and as the universe of investors broadens, so returns will fall, documentation will become more sloppy and permissive and ’ere long we will have the CoCo equivalent of “cov-lite” knocking at the door.

I RECALL A conversation I had some years ago with a major Frankfurt money manager when he pleaded with me for us, the investment banks, to push for tighter protective covenants on corporate bond documentation. I explained to him that it was up to the lenders to stand up for themselves – investment banks receive their fees from the borrowers, not the lenders – but as the only sanction open to investors was not to buy a bond and unless all buyers went on strike together, nothing ever happened. As the mad scramble to get allocations in bonds that would eventually enter the indices took priority, covenant-related doubts were soon forgotten.

The irrational rationalisation for CoCos is of course that we are just exiting a credit crisis, that the regulatory authorities are extremely vigilant, that the boards of banks and insurers are scared stiff of excessive risk and that therefore the risk of the trigger point being hit is as good as non-existent. In other words, CoCos are money for old rope.

To a certain extent I cannot disagree. Nevertheless, I have little doubt that sooner or later there will be issues out there that shouldn’t be and that folks who shouldn’t be investing in the asset will be sucked into buying. Never forget the man who fell off the Empire State Building and while sailing down past the second floor window thought to himself “So far, so good…”

Borrowing, lending and owning shares in a company are processes as old as civilised society. They have existed for eons and have developed over centuries. The near-collapse of the financial system five years ago had nothing to do with the weakness of the products but of the people who bought, sold and regulated them.

The introduction of a new asset class that defies the basic rules of lending, redefines the rights of lenders and the duty of borrowers and permits loans not to be repaid without triggering a default, should be treated with enormous suspicion. However, with 10-year Bunds at 1.50% and 10-year Treasuries at 2.00%, who is going to hang around long enough to argue with a 7% coupon?

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