The Case of Mistaken Identity
With recent news events bringing Contingent Convertibles into the headlines, the terms “convertible bonds” and “Contingent Convertibles” (also referred to as CoCos) may sound the same, but these are in fact quite different instruments, with their own separate investor bases, risks, and sources of return.
We thought it would be useful to review these differences and to highlight some of the features of our market of convertible bonds that we find especially attractive at present.
To start, the CoCos that have recently run into challenges are AT1 bonds. The AT1 market is limited to bank issuers where AT1 stands for “Additional Tier 1 Capital.” The structure of a junior claim AT1 CoCo is completely different to a standard convertible bond, which is almost always in line with the claim of senior unsecured (i.e. corporate bonds). These bonds did not form any part of our investment universe, nor have we ever held AT1s.
Let’s review AT1 bonds, which are reverse convertibles. Holders receive a higher coupon, but have a junior claim bond where they can only get back par (100%). It is critical to note that the option to convert is not for holders to exercise—it depends on banks and their regulators. Holders of AT1 bonds take on the risk that their bonds convert into something worth less when a bank’s equity base loses value and the bank falls below regulatory minimum levels for Tier 1 capital ratios. These holders get a higher coupon for taking on that risk of forced conversion. Or, in finance theory terms, AT1 holders get a higher coupon because they are selling the right to be converted (and possibly lose par value) to the issuer.
There are basically two outcomes that apply to AT1 holders if a reverse conversion occurs.
• The AT1 bonds convert into equity according to a set ratio; the value of equity at that point is usually less than par value (100%) of the AT1 bonds.
• The AT1 bonds lose all value and move out of the bank’s liability structure. With no more AT1 bonds outstanding, the issuing bank’s equity capital ratios increase (Assets = Liabilities + Equity) and Tier 1 capital ratios move above regulatory minimum levels.
CoCo/AT1 holders were yield-focused. Holding AT1s meant that they were being paid (in the form of a higher coupon) to take on the risk that their claim would lose value if the bank’s equity value fell. The key question for the CoCo/AT1 market is whether these investors were sophisticated enough to analyse what is potentially a material risk of a bank falling below regulatory capital ratios and triggering a conversion or other loss of value for these instruments.
By contrast, what are convertible bonds? Quite simply, a corporate bond plus a call option to convert into equity. They are issued by a broad range of companies across all sectors, and can rise in price above par (100%). The value of the embedded option means that the coupon of a convertible is lower than for a straight corporate bond, but the embedded option can create future value for holders.
• If the underlying stock price rises, the value of the option increases, and drives the price of the convertible higher.
• If the underlying stock price falls, the bond element remains in place until maturity, unless the issuer becomes distressed.
Our Redwheel portfolios only hold convertible bonds. We are willing to exchange a source of return by accepting a lower bond coupon for an embedded equity option, which holders choose to exercise (unlike an AT1). That conversion option can provide upside if the underlying stock price rallies, and holders of convertible bonds can generally choose when it is ideal to exercise that option. Because convertible bond holders are willing to pay a little to wait for equity upside, we analyse the potential future value of an underlying equity as well as the issuer’s credit. That means that we are looking for things that can go right as a source of return.
Now, with bond coupons returning to positive territory since rate hikes began in 2022, we are getting paid to wait for equity upside. The presence of a bond floor also means that we are limited from damage from a falling stock price, compared with holding a position in the underlying equity. This convexity of potential returns (i.e. more upside potential than downside risk) is the foundation of why we see convertible bonds as an attractive diversifier for investors.
We don’t see any problems with AT1 CoCo bonds affecting issuers in our market. The convertible bond market is an alternative for corporate (i.e. non-bank) bond issuers. If anything, wider credit spreads, rising volatility, and higher coupons should make convertibles look more attractive than raising a straight bond in today’s market conditions. This makes convertibles attractive both to corporate issuers as well as to investors.
No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment. Past performance is not a guide to future results. The prices of investments and income from them may fall as well as rise and an investor’s investment is subject to potential loss, in whole or in part. Forecasts and estimates are based upon subjective assumptions about circumstances and events that may not yet have taken place and may never do so. The statements and opinions expressed in this article are those of the author as of the date of publication, and do not necessarily represent the view of Redwheel. This article does not constitute investment advice and the information shown is for illustrative purposes only.