Coco fund offers bond diversification

Contingent convertible (coco) bonds carry conversion risk but promise high yield with low volatility and diversification, according to Lloyd Harris, fixed income fund manager at Old Mutual Global Investors.

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London, United Kingdom – August 28, 2013: The headquarters of State Street Corporation at Canary Wharf in the financial heart of London pictured against neighbouring buildings.

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“[Cocos] are negatively correlated to US treasuries and for UK gilts and corporate bonds, it is close to zero,” he told Portfolio Adviser sister publication Fund Selector Asia during a recent visit to Hong Kong.

He added that cocos are more correlated to equities, exhibiting their nature as “true hybrid” securities. The correlation of cocos to the MSCI World is 0.57 and 0.39 with the S&P 500.

Cocos offer relatively high yield and low volatility during a time of low interest rates and increasing volatility, Harris said.

He added that the asset class is also undervalued because the conversion feature makes them more complicated to analyse than equities and standard bonds.

Cocos are debt instruments issued mostly by banks and some insurers that are convertible into common shares when triggered, either automatically – by the issuer’s stock price or capital measures – or at a banking supervisor’s discretion.

They should not be confused with convertible bonds, in which the holder has the option to convert the bond into equity, Harris noted.

Investment process

Harris co-manages with Rob James the $235.4m (£178m) Old Mutual Financial Contingent Capital fund, which is a pure coco fund that was launched in August last year.

This is not the first time that the firm has invested in cocos, Harris noted, adding that the firm’s other fixed income funds have some allocations to the asset class.

Old Mutual Financials Contingent Capital performance

1m 3m 6m 1yr 3yr
Old Mutual Financials Contingent Capital I Inc 0.64 2.81 -0.62
FO Convertible 0.87 1.38 0.68 0.72 24.49
Source: FE Analytics

The fund’s investment universe includes cocos issued predominantly in developed markets. The majority of its assets are invested in the UK and in Europe, according to its factsheet.

When investing in cocos, Harris likes high quality banks, which are those that have good credit health.

“The big part of the investment process is looking at their credit fundamentals and monitoring their capital health.” He also looks at whether the loans the bank gives are also of good quality, he added.

Assets of the fund have increased from $100m when the fund was launched.

Risky bet?

One big risk that cocos carry is the conversion to equity, which would amount to a haircut on their value, similar to that applied to other types of debt in case of bankruptcy resolution.

The triggered conversion into equity is designed to recapitalise the bank at times of financial distress, in order to avoid the necessity of a taxpayer-funded bail-out.

Cocos were introduced by banking regulators in the wake of the global financial crisis of 2008.

A Bloomberg report referred to cocos as “a high yield investment with a hand grenade attached” and cited the 2017 case of Spain’s Banco Popular Espanol, “when regulators wiped out investors in €1.25bn ($1.4bn) of coco bonds”.

Harris believes that the risk of conversion remains benign.

“In reality, we think that getting into conversion is extremely remote,” he said, adding that banks are better capitalised now compared to 2007.

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