Covid-19 has led to a collapse in real yields, creating a double-whammy for schemes of falling returns and increasing liabilities. James Macdonald asks if CoCo bonds can provide an opportunity for schemes in such an environment.
Funding constraints remain the biggest single challenge for pension funds, and this has been exacerbated by the response to Covid-19. As of June the combined deficit of UK defined benefit schemes sat at £174.3bn, with 66.8% of all schemes in deficit versus 58.6% just a year ago. Real yields have collapsed, driven by quantitative easing, which has pushed $15.5trn (£12bn) of global assets into negative yielding territory, creating a double whammy for the industry, with both liabilities increasing in value and asset return expectations collapsing.
Over the past decade the trend has been for funds to de-risk their portfolios by favouring gilts and corporate bonds over equities, illiquids over liquids and trackers over active. However, with yields collapsing, deficits growing and the outlook uncertain, finding yield and assets that will benefit, rather than suffer, from the current policy response, is a growing problem.
We believe contingent capital bonds (CoCos) issued by banks, and more commonly held in the realms of sophisticated asset managers and hedge funds, fit the bill for these issues, and should increasingly be finding themselves on the radar of pension fund allocators.
The European banking system provides 80% of the credit to the continent's economy. As the crisis has unraveled we have witnessed a unique alignment of fiscal, monetary and regulatory actions, all designed with the mindset that banks are the conduit of ensuring the policy actions taken from a monetary and fiscal perspective reach the real economy.
The importance of the banking system's role in helping the economy recover from the crisis cannot be underestimated, and this has not been lost on regulators and policy makers. Regulators have made sure that banks benefit from capital relief and support measures to ensure they have no concerns about solvency and stand willing and able to provide as much credit to the economy as it demands.
Aren't banks a bit risky, particularly during a recession?
In the aftermath of the global financial crisis, regulators spent the best part of a decade driving banks to have better liquidity, hold more capital and engage in less risky activities through greater capital charges levied on so-called risky activities.
This decade of reform has meant the European banking system has started this crisis from a position of strength. While we are undoubtedly entering into an environment now where the sector will be tested, we remain confident that European banks will emerge from this far better and more resilient than the market expects. Further to this, we believe the importance of banks in the monetary transmission mechanism and provision of credit, will ensure ongoing policy support from regulators to ensure that this position of strength will be maintained.
The cost of this decade of reform and unprecedented support has been meaningful for bank equity holders, who have picked up the tab of increased capital requirements and dividend bans to share in the pain; yet in our view it has presented a rich opportunity for bank credit investors willing to do their homework.
Where is the sweet spot to benefit from the policy environment?
The CoCo market is a product of the financial crisis of 2008/2009. These are hybrid debt instruments issued by banks that were designed by regulators to act as shock absorbers if financial institutions ran into trouble again.
We believe CoCos offer investors the best of both worlds - equity-like returns through fixed income instruments - and appear to be the sweet spot in playing the to the strength of the banking system and policy support without potentially suffering from the cost of this support like equity holders.
The CoCo premium
Almost 25% of CoCo bonds for the European banking sector are investment grade-rated, and the rest high yield (although usually issued by investment grade rated banks). Despite this, they don't feature as part of these benchmarks due to their unique characteristics.
With the rise of passive investing and ETFs, any instruments that don't tick a box - or fit within a predefined benchmark - frequently trade with a significant discount and may often present a mis-pricing opportunity to potentially exploit. In our view it is hard to think of an asset class where this is more apparent than the market for CoCos.
Fitting the bill
For pension fund managers that are not constrained by benchmarks and are in search of strong risk-adjusted returns, there is a potential opportunity to invest in this asset class and gain exposure to a sector which, in our view, has improving prospects and policy maker support, yet with highly attractive yield.
When you survey the risk spectrum, we believe it is hard to find risk-adjusted returns that look quite so compelling.
James Macdonald is a portfolio manager at BlueBay Asset Management
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