CoCos and AT1 – cheap or still dangerous?

Banks are as safe as houses, till the moment they aren’t. Investment banks think the AT1 hybrid capital market looks cheap on the basis higher rates are good for banks. Rising defaults.. not so much. Bank hybrid capital is a complex area and not for the faint-hearted or ill-informed.

Blain’s Morning Porridge – Jan 19th 2023: CoCos and AT1 – cheap or still dangerous?

“You can polish a t**d till it shines like a diamond, but essentially it’s a t**d.”

This morning: Banks are as safe as houses, till the moment they aren’t. Investment banks think the AT1 hybrid capital market looks cheap on the basis higher rates are good for banks. Rising defaults.. not so much. Bank hybrid capital is a complex area and not for the faint-hearted or ill-informed.

Sorry for late morning porridge, but it’s been a very busy morning not getting to London due to landslips undermining the tracks, and it apparently being too cold for the electricity that powers the trains – which weren’t going anywhere anyway…

One of the great marketing tricks in financial services is to give things really interesting names that make them sound really exciting, sparkly and modern. The inference is exciting products will produce greater returns. Nope. Marketing flippetery. Whole new financial sectors then emerge around these bright new investment firmaments…

Yesterday a financial strategist with a highly successful record in managing equities contacted me for my thoughts on Contingent Convertible Bonds issued by Banks – variously know as hybrid capital, COCOs or Additional Tier 1 Securities. He remembered me from my days running FIG (Financial Institutions) at a couple of investment banks back in the days. AT1 fail the exciting name test – which is probably a good thing as the primary rule of investing in banks is to buy: Dull, Boring and Predictable.

As an equity man, my chum is naturally suspicious of anything with a whiff of fixed income debt about it.. What piqued his interest was a note he received from a prestigious investment bank saying the AT1 capital instruments look cheap relative to the rest of the credit markets.. He is right to be concerned. To buy a very complex financial instrument just because a US bank says they are cheap… that would be daft. Guess what – AT1 spreads are tightening..

To really understand all the risks embedded within AT1, hybrids, CoCos, you really need to understand everything about the underlying risk of each individual issuing bank. Over the 10-years since the first CoCo/AT1 issues, these risks have changed substantially. Banks have been largely derisked – effectively much of the market risk they used to wear is now held within the investment industry, held by pensions funds, insurance companies and across asset management – but that’s a looming horror story for another day.

Central banks/Regulators have made the monitoring of banks front and centre in terms of stress-testing them to demonstrate to a sceptical market (recovering from the shock of 200) banks are sound, while demanding  high Capital (CET1) ratios to ensure we never, ever again see the kind of cascading bank capital crises we saw in 2008-09. It’s worked. We now seem to be forgetting the lessons learnt during the GFC: I can’t remember the last time I saw a comment on the front page of the FT about bank stress tests, or anything deep and meaningful about bank capital risks.

These are not the droids you are looking for. I am told there is no chance of the kind of 2008 banking crisis that saw billions wiped off notional mortgage exposures and commercial lending ever happening again. I am told banks with 15% CET levels aren’t going to experience crisis. I am told the regulators are all over the risks. Sure, it will never happen again.. right up to moment it does.

I reckon global regulators are very well prepared to refight the last financial crisis – which, unfortunately, won’t be the one that hits banking next.

So, this morning I have been perusing the Bank research note on AT1s. It generally looks at the AT1 market and says rising rates are good for banks so AT1 yields look relatively more attractive. They analyse the yield on the bonds to call, and non-call and conclude they are cheap on a relative basis. They suggest investors compare banks to their ratings “cohort” for which ones to buy. Doh!

That is not the way banks die. Banks are about confidence. When confidence dies so does the bank. The most significant banking crash I remember post 2008 was Banco Popular which plunged into collapse in 2017. In 2007 it was one of the last AAA banks in Europe. 10 years later there was a run on the bank after its mortgage losses became apparent. Liquidity dried up. It became non-viable. Its AT1 were written down, and Santander bought the bank for a Euro. It happened fast.

As I read through the bank research note on CoCos I felt like the mad old character warning bad things are coming… Can’t they see past their enthusiasm?

COCOs.. they still make me smile. Back when they first emerged in 2013s I wrote they were the “bastard stepchildren of deranged regulators and desperate banks.” Regulators see themselves as very considered, sensible, prudent, august personages making financial markets safe for all. They lost the plot in 2007/08.

I quickly perceived CoCos to be a rather rushed compromise in the wake of the Global Financial Crisis (“GFC”) when governments bailed out struggling “to big too fail” banks with billions of rescue loans, regulators were trying to re-establish their primacy, and banks were desperate to recapitalise themselves.

By bailing out the banks in 2008 governments became large shareholders of worthless financial intermediaries. It was massively unpopular, but it’s fair to say the owners of banks, the equity holders still suffered as stock prices collapsed. However, because the banks never actually went bust – they never defaulted on their debt. Despite the credit markets pretty much flatlining during the crisis – holders of bank capital in the form of Tier 1 debt, in the form of preferred securities, got their money back.

I checked the porridge archive and found this comment on the first modern CoCo issued by Barclays back in 2013:

  • A well polished coprolite may be pretty, but it came from somewhere – and that somewhere was a dinosaur’s bottom…” : CoCos may be just about the most dangerous weapon of financial destruction yet conceived. Heaven help us if they ever get into the hands of the financially deranged.. Oh.. Barclays have just launched one… I’m equally surprised they are sponsored by such august bodies as the Bank of England’s Prudential Regulation Authority (PRA). Beats me why they have encouraged allowed a binary flip product that could trash investors overnight, and turns the long-established subordination ladder basis of finance on its head. The new Barclay’s deal is not a Knock-out CoCo.. it’s something new and therefore untarnished. It’s an Additional Tier 1 Contingent Convertible Security – AT1. New Name. Same old solids.

Back in 2013 there were predictions the AT1 market could quickly grow to $400 bln. 10-years later it’s a $240 bln market – and confined to institutional investors only. It small, its specialist and its niche – but well worth watching.

My problem with CoCos was how they turned conventional bond wisdom on its head – by making AT1 effectively the first loss capital of a bank. If a bank has taken sufficient losses to breach its capital levels – or regulators decide its bust (reached the point of non-viability), the AT1 bonds are either written off or convert to equity – which will be effectively worthless. Other bank bonds, Tier 2 and senior debt, follow the conventional rules of subordination – meaning senior debt holders are repaid ahead of subordinated holders.

Now I don’t care so much.. CoCos are what they are.. But I do care if folk don’t perceive the risks.

AT1s/CoCos remain far more equity like than debt-like. The risks are largely equity risks – that a sudden liquidity event hitting a bank, triggering a run or collapse in the ability of the bank to fund itself, could very quickly consume capital or cause regulators to declare it “non-viable” triggering a write down of the AT1 (or conversion into worthless equity). Such a liquidity event may come from cybercrime, fraud, or conventional sources such as increasing loan delinquency – which is likely to happen if rates are rising. Or it may come from a major fund going bust on the back of some event, trigger a systemic hit on its lenders’ balance sheets.

There are multiple reasons why things could still go to rack-shit in a heartbeat across the banking industry. The threat may be less than in 2007/08, but it’s not negligible. You need to understand the capital structure, the risks it covers, and the ability of the bank to manage these risks. And all banks are different..

And never forget, when an investment bank tells you complex financial instruments are cheap and you should buy them, you first thought should be how long and wrong they are…

No time for five things this morning..

Out of time and back to the day job..

Bill Blain

Strategist – Shard Capital


  1. Coco bonds, subordinated to equity or contingent to zero, they have one guarantee, to stimulate an involuntary shudder. Always read the full prospectus, not the initial term sheet. Initially they were issued with a conversion to equity. Great suddenly you own the equity at the low? No, if the shares bounce afterwards, the issuer had the option to cash you out if the shares traded up taking the profit. If they trade down you own them. (CS deal?)
    The next manifestation was a contingent conversion to zero, if triggered the bonds are cancelled, the shares continue to trade and benefit from the write down of the debt. (First seen from Nomura, but copied by the crowd).
    What triggers them? CET1 dropping below a specified level, yes, except the regulator can also force the trigger. It’s in the prospectus, check the trigger events, regulatory requirements and such chat. Some were even issued with a CET1 trigger level below the regulators stated floor. I always laughed when bodies said they were modelling their value.

    • Ah… they didn’t listen to us then Ben… I doubt they will listen now..

      Bottom Line is not all banks are bad. Some are excellent investments. But every bank is different, and to invest in complex equity like instruments you need to understand all the risks pertinent to that bank – not so much the index of similar “ratings-cohort” names…


  2. I think you do a disservice to CoCos. Your comments about the riskiness of banks might be 100% true but they would apply equally to investors looking at putting money into bank equities. Banks can blow up: who knew? So the question about CoCos is how the risk- (i.e. volatility-) adjusted returns compare with other assets in the capital structure. It doesn’t make much sense to simply say they are rubbish – you have to look at relative valuations. CoCos have been the best performing sector of the fixed income market in several years since their creation and, not surprisingly after such outperformance, there have been times when they became very expensive, with many issues yielding in the 2-3% range. At such levels, I have no trouble agreeing with you that they should be avoided. But when, as now (even after the recent rally from levels that were obviously attractive, in my view), they offer equity-type returns with less volatility than the underlying equity and significantly greater downside protection against all but the most extreme events, they represent a desirable alternative for equity investors – which is presumably what was behind the question from your equity investor yesterday – as well as being worthy of a place in credit portfolios. Your answer might be an argument for avoiding the bank sector entirely, but it is not an argument against CoCos. Check out the performance of CoCos versus the underlying equities and you can see that it’s a sector worth looking at. Moreover, because so many people fail to understand the product, they often offer excellent value, especially after broad-based risk-off episodes.

  3. I had to look up the definitions of AT1 and CoCos. CoCos don’t look much different than a preferred share in a bank. Right now JPM.PD is about par and therefore yields 5.75%. I believe that they are regulatory capital. An article that I saw from PIMCO states that the European CoCos and contractually converted while the US AT1’s are converted at the option of the regulator. I don’t discount the chance of anything happening any more, like either JPM going bust or the US Treasury failing to redeem US Treasuries. I am not putting my t**ds all in one basket.

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