CoCo bonds: burdened by rising interest rates and Russian bonds

CoCo market credit spreads as measured by the ICE BofA Contingent Capital Index, widened by 41 basis points during the quarter. Credit spreads started the 1^st quarter of 2022 at 294 basis points, reached its intra-quarter peak at 446 basis points on the 7^th of March, and then recovered impressively to end the quarter at 333 basis points.

Participating in new issues

The primary market saw 6 new CoCo bonds issued during the quarter of which 3 were placed in January (BNP, Credit Agricole and UBS) and another 3 were placed in March (Deutsche Bank, Intesa Sanpaolo and Rabobank). We participated in 2 of the new deals issued in March, which we found attractive following the intra-quarter repricing of credit spreads.

Many bonds have been called

Another important theme in the CoCo market was the large number of calls announced during the first quarter with no less than 13 banks having redeemed or announced redemptions of outstanding CoCo bonds at the 1^st call date. This is in line with our expectations and means a significant amount of cash is paid back to investors during 1H2022 needing to be reinvested in the market.

Russian contributions

The exclusion of Russian CoCos from the benchmark depressed the benchmark's performance by -1.69% in Q1. At the end of 2021, the share of Russian bonds in the benchmark was still 2.1% and then declined via 1.9% (end of January), 0.6% (end of February) to 0.0% as a result of the complete exclusion. The affected banks include Alfa Bank, Credit Bank of Moscow, Sberbank and Sovcombank. Fund manager Daniel Björk was not invested in Russian bonds at all and was able to generate a significant outperformance in Q1, not least because of this. Björk: «We excluded Russian CoCos based on an assessment with ESG criteria and had not been invested in Russian CoCos since 2014.»

Overweight credit risk, underweight market risk

Market expectations for 2022 had been be implemented by portfolio strategists with an overweight in credit risk and an underweight in market risk. The concrete implementation was done via overweights on interestingly priced short duration CoCo bonds of issuers with a slightly higher beta than the market (overweight credit risk), offering a high carry and roll-down the curve for a low duration risk. The underweight of market risk is done by underweighting long-duration CoCos.

View on the banking sector: Still positive

Our positive view on the banking sector is based on good profitability and strong balance sheets with record-strong capitalization. In addition, the underlying economic growth data are holding up well despite headwinds from high inflation. However, the combination of high spot inflation and solid growth represents a window of opportunity for central banks to aggressively dial back on monetary policy support during the coming year(s). In such an environment Issuer and Security selection as well as overall Credit Beta management are crucial. In terms of Issuer selection, we find it attractive being overweight credit risk since we continue to see good value in several banks with slightly higher beta (in both Europe and LatAm) due to the solid growth environment, improved balance sheet strength and cheap valuations. In terms of Security selection, we like being underweight market risk since we find the risk/reward unattractive for many longer duration Coco bonds. Hence, we continue to prefer high coupon bonds in the short end of the curve (<3 years) with low extension risk, we avoid low coupon bonds with longer duration and higher extension risk. We think many of the high coupon short duration CoCo bonds could provide some of the strongest returns across fixed income during this year.

Active management is crucial

While 2022 is shaping up to be a challenging year for investors with plenty of uncertainties to navigate (high geopolitical risk, high inflation, likely aggressive reduction of monetary policy support), we believe that active fund management combined with a solid through-the-cycle investment process are crucial in the current environment.