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Corporate Bonds 2019

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C O R P O R A T E B O N D S - T R A N S F O R M I N G T H E M A R K E T 8 Should the coco bond ban be lifted? Deemed as unsuitable to the needs of ordinary retail investors, bank contingent convertible bonds may not be as risky as once thought ontingent convertible bonds, or cocos, are bonds issued by banks and financial institutions that can be converted into equity in certain cirum- stances, for example when a bank's regulatory capital falls below certain levels. Issuance has grown rapidly from 2014 as banks sought to meet higher Basel III capital requirements. They have been unavailable to ordinary UK retail investors since 2014, but many in the market argue the ban should now be lifted. In October 2014, the UK's Financial Con- duct Authority (FCA) introduced a set of intervention rules, which became permanent in 2015, that restricted the retail distribution of cocos to ordinary retail investors but gave certain exemptions to wealthier and more sophisticated investors. In explaining the move, Christopher Wool- ard, then-FCA director of policy, risk and research, acknowledged investors might be tempted as cocos offered high headline returns in a low interest rate environment. "However, they are complex and can be highly risky. The FCA has used its new powers to ensure that cocos are not inappropriately made available to the mass retail market while still allowing access for experienced investors," he said. The move was not without controversy and the FCA's market consultation prior to making the rules permanent attracted a range of opposing views to the restriction on ordinary retail investors. The FCA pointed out how little experience the market had of how cocos operate. Yet five years on since the move, no Ster - ling coco has defaulted and financial insti- tutions have a full decade of experience in using contingent convertible securities. According to Credit Suisse, since 2010 Ster- ling cocos have returned 11.6 per cent per annum and over the past 12 months 12.2 per cent. More striking is that over the same period UK bank equity has lost 2.6 per cent per annum and lost 9 per cent over the past 12 months according to the FTSE All-share Bank Index. Rezaah Ahmad, founder of digital bond market WiseAlpha, says: "When you consider that retail investors are limited to investing in the listed equity of banks but are blocked by a combination of regulator policy and the cor - porate bond market from investing in lower risk bank debt or coco securities issued by the same company, you naturally end up with perverse consumer outcomes, antithetical to the aims of regulators." Compared to the potential risks from other investments, such as equities, contracts for difference, peer-to-peer lending, equity crowdfunding or cryptocurrencies, is there now a case to revisit the restrictions placed on cocos and begin to open them up to individ - ual investors? Denise Yung, portfolio manager in Lom- bard Odier Investment Management's fixed income team, explains that because cocos are designed to absorb losses when an issuer's capital ratio falls below a cer- In response, global regulators have sought to rectify this situation by clarifying and co-ordinating how subordinated debt instru- ments should function in times of stress and, in particular, under what circumstances con- tingent capital bonds should be activated. "This is now embedded in underlying bond documentation, but the assessment of whether a bank has reached the point of non-viability is also subject to regulatory dis- cretion," he says. "All in all this means that assessing the risk and complexity of contin- gent capital bonds can be nuanced." Concerns around the complexity of the instruments are more well founded given the variety of features and the relative infancy of the asset class compared with equity and other debt instruments, Ms Yung agrees. To make the instruments more accessible to retail investors, it would help to see a stabili- sation in banking regulations and a standard- isation of contractual terms to create a more homogeneous asset class, she argues. "Concerns could also be addressed by edu- cating investors to increase their knowledge and by applying an appropriateness test to check investors' understanding of the instru- ments," Ms Yung concludes. Rezaah Ahmad, founder of WiseAlpha, says perhaps there is also something to learn from the retail market review that the FCA has been conducting in the peer-to-peer lending space. Over the past five years the FCA abstained from placing any restrictions on retail invest- ment in peer-to-peer lending while it observed, learnt and implemented rules for the industry. The extended FCA review of the P2P mar- ket allowed a natural testing period to occur, forming the basis for the FCA to conclude that it would be suitable to introduce an appropri- ateness test for retail investors coupled with a limit for retail customers new to the sector of 10 per cent of investable assets. Christopher Woolard, the FCA's executive director of strategy and competition, said the changes were about "enhancing protection for investors while allowing them to take up inno- vative investment opportunities. For P2P to continue to evolve sustainably, it is vital that investors receive the right level of protection." Would a similar approach towards the coco market help create the industry condi- tions necessary for mainstream retail mar- ket participation? C Nicola Tavendale Excellent partnership@wisealpha.com C O C O S Their perceived riskiness is somewhat incongruous as cocos are arguably less risky than other securities $675-billion in cocos outstanding worldwide by 2017. Most cocos paid a coupon of between 6 and 9 per cent at the start of 2019, with yields continuing to attract institutional investors in the ongoing low interest rate environment. According to a European Parliament briefing, cocos are also attractive to issuers because they help them satisfy regulatory capital requirements. In addition, equity is more expensive than debt in the sense that borrowers face less risk than shareholders. However, Bjorn Norrman, investment manager in the fixed income team at Kames Capital, warns that while it is true equity investments are seemingly riskier, given they sit at the bottom of the creditor hierarchy, bank equity is still a cleaner and easier-to-un - derstand investment. "Investing in cocos requires intimate knowledge of bank and/or insurance capital regulation and, more specifically, under what scenario a bond may be converted to equity or coupons cancelled. Without this understand- ing it is problematic to assess the risks or estab- lish likely returns," he explains. "The high thresholds to investing in con- tingent capital are deliberate; regulators remain keen to protect direct investors from the allure of pure high coupons, not wanting that on their watch." Among the many anomalies and unin- tended consequences created during the finan- cial crisis was the issue of bank subordinated debt instruments that qualified as capital and were supposed to be loss absorbing, but often proved not to be, according to Mr Norrman. tain level, to fulfil this purpose they have a combination of equity and debt-like fea- tures, which does make them riskier than other debt instruments. "The FCA restricted the retail distribution of cocos due to the riskiness and complex- ity of the instruments. The intention of the rules is understandable given the numerous mis-selling scandals in recent years and the attractive yields offered by cocos in an envi- ronment of low interest rates," says Ms Yung. "However, in our view, the perceived riskiness of the instruments is somewhat incongruous as cocos are arguably less risky than other securities that are availa- ble for retail distribution." Although there have been no problems for UK issuers since the launch of cocos, in 2017 Spanish bank Banco Popular Espanol had its additional tier 1 cocos fully written down after the European Central Bank determined it to be "failing or likely to fail" and it was sold over- night to Santander. Banco Popular's equity and tier 2 debt, which ranked below and above its coco securities in the capital structure, was also wiped out, highlighting that while these are investments in highly regulated banks the risk of losing the entire investment remains. Nevertheless, cocos have become a very popular financing tool and issuance has con- tinued, mostly recently in emerging mar- kets such as those in Asia-Pacific, with some RISE OF THE COCOS Cumulative issuance; additional tier 1 bonds sold by European banks (€bn) Bloomberg 2019 Contingent convertible bonds, or cocos, are a complex instrument that's a cross between bonds and a stock. They are widely seen as riskier investments than other debt instruments, designed to absorb losses when an issuer's capital ratio falls below a certain level as the securities are convertible into equity when a pre- defined "strike price" is triggered. They have been unavailable to ordinary UK retail investors since 2014. What are cocos? 2014 2013 50 0 100 150 200 2015 2016 2017 2018

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