We asked BlueBay’s Marc Stacey and James Macdonald why they think it might be different for select banks this time round
It's an interesting time to be a fund manager investing in contingent capital bonds or CoCos - hybrid debt instruments designed after the 2008 financial crisis to act as shock absorbers if a bank runs into trouble.
Stacey and Macdonald, who manage BlueBay's Financial Capital Bond Fund, have argued for years that this kind of subordinated debt may represent a sweet spot in the bank capital structure, so long as the issuer is robust. Will the corona crisis be the test of fire that proves their reasoning?
CoCos help bank regulators relieve and recapitalise troubled banks through a variety of mechanisms, such as the suspension of CoCo coupons, and converting CoCo debt into equity or writing it off if certain triggers are reached, e.g., the bank's core Tier 1 capital falls below a given ratio. In return for accepting this risk, investors are paid relatively generous coupons.
The BlueBay team say that between 2008 and 2020 a gap opened up between the high yields available from CoCos and an apparent reduction in bank risk caused by:
• Banks increasing their liquidity and moving business models away from market risk and more towards safer net interest margin, advisory, asset management and other fee-paying businesses
• The amount of equity capital on bank balance sheets increasing from around 6.2% before 2008 to around 15% in 2019 (1)
"The equity buffer sitting beneath us in the capital structure grew to such an extent that, to us, it seemed likely to absorb even very harsh economic shocks," says Stacey.
The team thinks CoCo yields remained high partly because CoCos are a relatively novel and complex instrument - absent from most fixed income indices and unattractive to constrained investors. "With the rise of passive investing and ETFs, fixed income instruments that don't fit into a box seem to trade with a discount," says Stacey.
But will the team's reasoning survive Covid-19 and a protracted climb in bank losses, for example from the default of overleveraged corporations? The team say the role of banks in this crisis is very different to their role in 2008.
"The virus created this macroeconomic situation and today banks are part of the solution because they are part of the monetary policy transmission mechanism," says Macdonald. To avoid a credit crunch, "when coronavirus struck it was almost essential for many policy makers to come up with government loan guarantee schemes in addition to offering banks cheap access to liquidity," says Stacey.
Those schemes have dampened the initial impact on banks but what about the later stages of a slow recovery? "As government support roll offs, that is indeed when you're likely to see actual bank losses rather than projected losses," says Macdonald. "But at that point, you'll hopefully be seeing some form of economic growth."
The next few years may still prove a precarious time, especially for systemically unimportant or weaker banks and those exposed to idiosyncratic risks. That's why the team focuses on issuer selection - particularly identifying European banks that act as ‘national champions' - and tracking the thinking of regulators and policy makers, as well as the specifics of each instrument.
(1) Common Equity Tier 1 (CET1); source: European Banking Authority
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