A new species of bank bond called contingent convertibles, CoCos for short, offers yields far above what more senior bank bonds pay.
But CoCos are not ordinary bonds that get paid even if the issuing bank’s balance sheet shrivels. Rather, if the issuer’s capital falls below a designated level, the bonds are converted to common stock and bondholders wind up holding shares of a bank with bad loans and little value.
The question for advisors is whether clients should buy into a potential disaster or stick with lower-yielding senior bonds.
CoCos and the Canadian version – called Non-Viability Contingent Capital (NVCCs) – were invented in the wake of the 2008-09 global financial meltdown and are convertible debt with a string attached. If the issuing bank’s regulatory capital – defined as common stock, retained earnings and certain preferred stock – falls below a specified level, the regulator can swiftly turn the bonds into shares. European CoCos have what are called “high triggers” – that is, capital requirements that are easily breached.
Canadian NVCCs have lower triggers that are not so easily pulled by regulators. That these bonds can be turned into common stock makes them deeply subordinated. In contrast to senior bonds that would be honoured or their holders bailed out, holders of CoCo/NVCC bonds would take the issuer’s losses in their pocketbooks. They would hold common stock in what could be a worthless bank having bad loans.
The risks are not just theoretical. Deutsche Bank (DB) has about 4.6 billion euros ($6.4 billion) in outstanding CoCos. As of late February, the yields on the DB 6% nominal yield CoCos, which were trading at 85 euros for a bond with a face value of 100 euros, yielded 13%, up from 7.5% at the start of 2016, according to Bloomberg LLP.
CoCos and NVCCs clearly are low-grade debt, but investors have rushed to buy them. After all, it’s hard to find government bonds that pay anything like they used to. Worse, central banks are testing the waters for “negative pay” bonds, which attract investors looking for riskless investments; these bonds ensure losses are less than they might be from stocks and corporate bonds.
Canadian banks remain solid. But the shock-absorbing NVCCs have attractive yields based on what could happen. For example, a Toronto-Dominion Bank (TD) 2.982% NVCC bond, callable on Sept. 30, 2020, recently traded at $98.21 with 276 basis points (bps) of yield over a Government of Canada bond of similar term with a 0.65% yield to maturity.
A senior conventional TD 2.563% issue due June 24, 2020, recently was priced at $102.71 to yield 1.97% to maturity, which is 132 bps over the Canada bond of similar term.
The question is whether the NVCC Canadian issue is underpriced, and thus a great value, or priced correctly for what may yet come to be. NVCC issues are generally rated at two notches down from the bank’s senior bonds.
Rating agencies have cut notches because the NVCC issues are subordinate: that’s one notch. The mandatory contingent conversion feature is the second notch.
Before choosing an NVCC, you need to ask how likely it is that a major Canadian chartered bank will cease to be viable. The Office of the Superintendent of Financial Institutions (OSFI)would, if minimum capital adequacy trigger points are breached, convert each NVCC note, without the holder’s consent, into fully paid and tradeable common shares of the bank.
How much risk is there in NVCCs? According to Chris Kresic, head of fixed income and senior partner at Jarislowsky Fraser Ltd. in Toronto, NVCC prices reflect the fact that Canada’s chartered banks were among the worst performers on the Toronto Stock Exchange in the past 12 months. “Bank stocks, in some sense, are a proxy for oil,” he explains. “Banks are under pressure from energy loans and from their uncertain position as new ways of clearing payments – like Apple Pay – develop. Yet, it is very unlikely that the banks would have their capital ratios so low that OSFI would trigger the NVCCs. It would have to be a depression scenario.”
For now, NVCCs are trading as just what they are – subordinated bank debt – and not as corporate junk, says Edward Jong, vice president and head of fixed-income for TriDelta Investment Counsel Inc. in Toronto.
CoCo issuance in Europe has all but ceased because of investor reluctance to accept their risks. However, Canadian banks continue to issue NVCCs.
On Feb. 26, for example, TD issued a 4.859% NVCC due March 4, 2031, and callable in 2026. It offers 360 basis points over a 10-year Government of Canada bond, and is the most recent NVCC issue in Canada.
How likely is it that TD’s capital would be wiped out in the next 15 years? “Not very,” says Jong. “But the bonds could get cheaper if lower interest rates arrive and compress term spreads and the resulting bank lending earnings.”
So, are NVCCs a buy? Yes, says James Hymas, president of Hymas Investment Management Inc. in Toronto. “The spreads over senior debt are attractive. You get a lot of yield increment for relatively little added risk compared to more senior bank bonds,” he says.
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