CoCo market to go mainstream after BoAML creates index

Fri Jan 17, 2014 7:24am EST

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LONDON, Jan 17 (IFR) - The creation of an index for new style bank hybrid debt instruments is expected to help transform them from a niche product into a widely-held asset class, just as the market readies itself for issuance to take off.

Since Lloyds issued the first contingent convertible (CoCo) at the end of 2009, market participants have argued that an index is needed for the sector to really expand.

The Bank of America Merrill Contingent Capital Index, utilising the COCO ticker, will track the performance of all contingent capital debt publicly issued in the major domestic and eurobond markets, including investment grade and sub investment grade issues.

According to Citigroup estimates, European banks will be incentivised to issue around EUR248bn of Additional Tier 1 debt and EUR266bn of Tier 2 to meet capital requirements imposed by CRD4. For 2014, the bank estimates that AT1 and Tier 2 issuance could reach EUR20bn and EUR45bn respectively.

"Benchmark inclusion for any new asset class is quite an important step in turning something which is quite esoteric and off-the-run into something which is more broadly held among institutional investors," said Roberto Henriques, financials analyst at JP Morgan.

Henriques cited the example of the legacy Basel II hybrid Tier 1 market. "Benchmark inclusion was one thing that really helped develop that asset class in 2003-2004 and was a significant driver in the growth of the market. We could see history repeating itself and it should facilitate the growth of the asset class over the medium- to long-term."

Henriques estimates that the AT1 market could see up to EUR74bn of issuance over the next two years.

"It is good for investors to have something to hang their hat on to," said Satish Pulle, lead portfolio manager at ECM Asset Management.

"It is also useful that CoCos have their own index and that they're not included in the regular investment grade or high-yield indices. From a regulator and systemic perspective, there is a recognition that subordinated instruments shouldn't be leveraged up."

Michael H√ľnseler, head of credit portfolio management at Assenagon, explained that it is often difficult for investors to distinguish a CoCo from an old style subordinated bond since the CoCo specific features are not readily observable without checking the prospectus.

"Hence, the index helps investors to distinguish between old style sub debt and new style CoCos."

Securities included in the index must have capital-dependent conversion features and must be rated by either Moody's, S&P or Fitch.

Index constituents are capitalization-weighted based on their current amount outstanding times the market price plus accrued interest.

The index contains 48 bonds for a full value just short of USD58bn. Since its creation at the end of December, the index's effective yield has dropped from 6.36% to 6.11%.

NOT ALL ROSY

While the creation of the index is clearly a positive, JP Morgan's Henriques said there was a risk that benchmark inclusion could "force" investors into the market.

"For investors who don't like the asset class and remain underweight, the risk is that the asset class goes into the benchmark indices against which they are evaluated. If the asset class then outperforms the rest of the market, the investors may end up significantly underperforming versus the benchmark indices should they remain underweight."

Meanwhile, Assenagon's Hunseler said that the index was at present way too concentrated to serve as a benchmark, with Lloyds accounting for 25% and Barclays for 14%. (Reporting by Helene Durand, editing by Alex Chambers, Julian Baker)

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