Blain’s Morning Porridge – March 21st 2023: CoCos, AT1s – Proved Right at Last
“You can polish a t**d till it shines like a diamond, but essentially it remains a t**d.”
This morning: The “rescue” of Credit Suisse, thereby averting a European banking crisis, is getting less comment than the nixing of its $17.5 bln of CoCo Bonds. I’ve been warning about CoCos since 2011. Finally I got something right!
As I read the details of UBS “rescue” of Credit Suisse, that manic howling guffaw that rent the calm of early Monday morning was me laughing my head off as I read about the nixing of it’s $17.5 bln CoCo bonds. Sorry, I should not be triumphalist – but finally my long-standing negativity has been vindicated! Nessun Dorma moment indeed…
My friend and mentor Harry Hindsight is the greatest trader who has ever lived. Even he now acknowledges I’ve been right all along about the dangers of Contingent Capital Bonds – CoCos! My first comment back in 2011 when they were first spawned in some foetid swamp of banking mediocrity was they were the Bastard Offspring of Deranged Regulators and Desperate Banks. I stick with that today.
Back in 2014 I came up with a new trading mantra (no 19): “CoCos are an inspired investment choice if your objective is own all the downside, no upside and less return than equity with much greater risk.” I will stick with that as well. Investment banks and fund managers have been telling me otherwise for the last 12 years.
Fear not! You may not have heeded my warnings, but I am are here to help. I am told the size of the CoCo market is some $280 bln (well, $262.5 bln after yesterday!) Don’t panic if you are a holder. I am pretty confident I can provide a bid on any CoCo bonds clients are looking to sell. You probably won’t like my bid, but in markets like this (where a promised bar of Gold has proven to be a complete Lemon), a bid is a bid is a bid and you should hit it harder and faster than the proverbial red-headed step-child.
(Seriously – if you need an exit, call/text/email me and we can help. I am out the office today, but will pick up!)
Let me apologise for the lack of Porridge y’day, but I’m in Edinburgh lecturing the next generation of financial leaders at the Edinburgh Business School on the realities of markets – a damn fine bunch they are as well. Yesterday we discussed banks and the disruption to markets caused by Additional Tier 1 Capital in the wake of Credit Suisse’s dramatic demise. My key comment to them was believe nothing until you have checked for yourself – especially the prospectus of complex deals. The message got through.
Back in the dim, distant days when Contingent Capital Bonds, CoCos, AT1s, whatever-you-wish to call them, were plucked from the ether of bad financial ideas, I warned they were a foolishly complex compromise nailed together with string and sticky back plastic to satisfy regulators about loss absorption and provide the illusion that debt holders would share in the pain of banks too big to fail being bailed out.
I have been consistently negative about them for the past 12 years – as usual.. Blain remains wrong till finally he was proved right…
I wrote about the dangers of CoCo’s just a few months ago – in January “CoCos and AT1: Cheap or Still Dangerous”. I warned:
“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, bond losses, 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…”
A reader commented:
“I think you do a disservice to CoCos. …. 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 as well as being worthy of a place in credit portfolios. 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.”
I rest my case..
As predicted, the nixing of Credit Suisse bonds turned the traditional subordination ladder on its head:, $17.5 bln of Credit Suisse lenders were written off while equity holders at least got enough back from UBS’s low ball bids to buy a poke of sweeties. Yes, the CoCo holders should have read the small print which clearly have the Swiss Regulator the right to unilaterally write off the bonds. If you faith and trust you place in banking bureaucrats, then expect to be disappointed.
Back in 2013 I spoke at a conference on Cocos and asked a simple question: “Why would I want to buy a CoCo yielding 5% and all the downside risk when the same bank’s stock carries a dividend yield of 6% and all the upside gains?”. A banker from Credit Suisse (I kid you not) told me how wrong I was and described CoCos in glowing terms as an ultra-safe debt investment route into banks. I said: “not so; CoCo holders get triggered while the bank is a going concern, therefore are subordinated to everyone else.”
I also rubbished the CS Banker’s claim banks would always call the perpetual AT1 bonds – rubbish I told him – referring back to the Great Perp Lower Tier 2 crash in 1986 (yes, I remember it well) when investors discovered banks don’t call bonds unless it makes economic sense to do so. I confidently predict anyone buying cheap, discounted AT1 bonds today (prices across the CoCo market tumbled 10-20% y’day) based on a yield to call calculation will be disappointed.
Funnily enough, the only bank that agreed with me was UBS – which declined to issue CoCos back in the early days. However, the UK regulator also thought CoCos were bad, ruling CoCos were a no-go investment zone for retail investors. The FCA said:. “in a low interest rate environment many investors might be tempted buy CoCos offering high headline returns. However they are complex and can be highly risky.” How right they were..
Apologies for the short and not particularly insightful comment this morning, but normal service will resume later this week..
Bill Blain
Strategist Shard Capital
8 Comments
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Brilliant. So true. Have been railing about these for years too.
And this drama isn’t over yet…as Ben Martin, Banking Editor, writes in The Times today…”A legal battle is brewing over the rescue of Credit Suisse after Swiss regulators stunned the debt markets by wiping out $17 billion of the troubled lender’s bonds as part of the deal.”
Thanks for the lesson on CoCos – something UK financial planners haven’t had to manage (thankfully)!
Oh dear – once again the CoCo bug has interfered with your logic circuits. Although the SNB’s decision to invert the capital structure in the CS rescue was damaging (which is why it prompted such a quick response from both the ECB and BOE reiterating that equity owners should be wiped out before CoCo holders), CS’s Cocos did exactly what they were supposed to do. Tier 1 capital should take a hit when a bank goes belly-up and the writing had been on the wall for CS for years. But why do you just focus on Cocos for your gloating? By your logic, you might as well now be laughing at the ‘idiots’ who invest in equities: Haha! I told you they were risky! I was wrong until I was right!! Seriously? As I said last time you attacked Cocos, no asset class is inherently good or bad: it’s a question of valuations. The Coco market is less liquid and has less depth than equity markets, so tends to move disproportionately in times of volatility, which is unhelpful from a mark-to-market perspective but also creates opportunities for those willing to think. As an example: you can buy a Deutsche Bank £ Coco today yielding more than 20%pa to its call in 2026. Unless equity investors expect DB shares to do better than that over the next three years, why wouldn’t they look at that? And, yes, of course DB could blow up, taking Coco holders with it, but equity holders would also be wiped out, so that’s not an argument against the asset class – it’s just a characteristic of it that needs to be priced in.
Cocos play an important role in the capital structure and regulators need the sector to function properly so that banks can raise AT1 capital more cheaply than pure equity (for obvious reasons). Again, this is why the ECB and BOE were keen to support the sector yesterday. You are very generously offering to help you clients exit Cocos at current levels: you would be doing them a better service by encouraging them to fill their proverbial boots.
CoCos are not like equity…
“CoCos are an inspired investment choice if your objective is own all the downside, no upside and less return than equity with much greater risk.”
Spot on.
Might I add that where there are still CoCos around that convert to equity under certain conditions (namely, the true “contingent convertible” bonds, as opposed to the merely forfeitable AT1s), the potential for shareholder dilution is also substantial. I don’t believe this is well enough understood, or communicated even remotely adequately to shareholders by the issuers (let alone by investment advisors).
I believe UBS issued a lot of these at some point. Not sure if they still exist.
Its immaterial if a bank’s AT1 is written off or converted to equity. When the trigger point is hit, the stock price will be in free fall and meaningless…
In effect the AT1 trigger is a banking death sentence…
“(where a promised bar of Gold has proven to be a complete Lemon)”.
You should have said “where the promised brick of nickel turned out to be a bag of rocks”.
We don’t have CoCo’s in the USA as far as I know but they seem a lot like perpetual preferred shares. I own some preferred shares but not in the banking industry where the regulators can shut you down in an instant. I want some bankruptcy court to protect my “preferred” status in the capital ladder.
Ha, very good