Capitol Report: U.S. mutual funds exposed to high-yield, high-risk Euro bank CoCo bonds

Some big U.S. mutual funds are investing in high-yield securities that overseas regulators warn may not be suitable to retail investors.

The securities at issue are called contingent convertible, or CoCo bonds. A recent Wall Street Journal report said contingent convertible bonds are ending 2017 with near-record low yields, warning that regulators should be vigilant if and when the bonds rally, since the high yields may attract more retail investors.

CoCo bonds, also known as additional Tier 1 notes, are hybrid capital securities with higher yields than better-rated debt from primarily European banks, issued to satisfy regulatory capital requirements. The securities absorb losses prior to, or at the point of, a bank’s insolvency by either converting into common equity or by taking a principal write-down triggered by the regulator or because of the decline of a specific capital ratio.

The British regulator has warned in the past about retail investing in these securities. Non-euro area investors hold €116 billion, or nearly 75% of the total amount outstanding of European CoCos, according to research published in February by Martijn Boermans and Sweder van Wijnbergen of DeNederlandsche Bank .

“In a low-interest-rate environment many investors might be tempted by CoCos offering high headline returns,” said Christopher Woolard, Financial Conduct Authority director of policy, risk and research, in 2014. “However, they are complex and can be highly risky, and the FCA has used its new powers to ensure that CoCos are not inappropriately made available to the mass retail market while still allowing access for experienced investors.”

That risk was on display in 2016, when Deutsche Bank faced a $14 billion fine from U.S. regulators over an investigation into crisis-era mortgage-backed securities transactions, the market worried the bank would stop paying pay coupons on its CoCos. That triggered a sell-off, closing the primary market for the securities entirely, according to a report in the FT.

CoCo bonds are “only suitable for those who have the ability to underwrite insurance on complex financial entities and who understand the shifting sands of European bank regulation. These two criteria probably eliminate the vast majority of CoCo owners,” wrote Jack Duval, the CEO of Accelerant, a securities litigation consulting firm, in February 2016 while the Deutsche Bank’s CoCos were crashing.

By September 2016, trading volume in Deutsche Bank’s CoCo bonds hit record levels and the price of the bank’s shares fell to new lows as the German government resisted calls to rescue the bank if it was unable to raise enough capital to pay the fines. By December, the crisis had been averted after Deutsche Bank agreed to a fine from U.S. regulators of $3.1 billion cash and $7.2 billion total, a reduction of nearly 50%. The non-cash portion consisted of “consumer relief” credits that will be spread over a number of years.

Read: Deutsche Bank crisis threatens to roil global markets

Middle-income households probably have almost no direct investments in European CoCos — the minimum investment for individuals was set at £200,000 by Lloyds, for example — but they could have indirect exposures via investment funds, wrote Boermans and van Wijnbergen.

John P. Calamos, Sr., the founder of Calamos, is generally credited for pioneering the use of convertible securities to manage risk and reward, but his namesake funds do not invest in CoCos at all, not even in a traditional convertible bond fund. “Because the risk/reward profile of these bank CoCos is the opposite of the risk/reward profile we look for in convertible bonds, [Calamos Investments is] quite willing to pass them by,” wrote Calamos’ co-chief investment officer Eli Pars in 2016.

CoCos typically pay higher coupons than a bank’s straight bonds but may have much higher potential downside. Pars blogged that Calamos funds are focused on convertibles that have upside equity participation with potential downside protection over full market cycles. A Calamos spokesman emailed MarketWatch to say the firm continues to avoid CoCos.

The Vanguard Group, however, discloses in several fund ”statements of additional information” to investors that, “with respect to the different investments discussed as follows,” some funds may acquire “hybrid instruments” such as CoCos . Vanguard describes the bonds as “fixed income securities that, under certain circumstances, either convert into common stock of the issuer or undergo a principal write-down by a predetermined percentage if the issuer’s capital ratio falls below a predetermined trigger level.”

MarketWatch found that some of the Vanguard funds that have disclosed the potential to invest in CoCos in documents other than the prospectus are not convertible bond funds or even fixed-income funds.

The Vanguard Explorer Value Fund summary says it invests in “small and mid-sized U.S. companies that, in the advisor’s judgment, are mispriced by the market.” The website descriptions for Vanguard Short-Term, Intermediate-Term, and Long-Term Government Bond Index Funds say they invest in debt with the appropriate maturities “issued by the U.S. Treasury (not including inflation-protected bonds) and U.S. government agencies, as well as corporate or dollar-denominated foreign debt guaranteed by the U.S. government.”

The Vanguard website says its Mortgage-Backed Securities Index Fund invests in U.S. mortgage-backed pass-through securities issued by the Government National Mortgage Association (GNMA), the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC). The Vanguard Russell Index Funds says it invests in stocks in the Russell Growth Index, a broadly diversified index predominantly made up of growth stocks of U.S. companies.

A Vanguard spokesman confirmed to MarketWatch in an email that “it does have an extremely small exposure to CoCos in very high quality banks.”

The Franklin Templeton Income Fund also discloses that it allows investment in bank-contingent convertible bonds.

When asked if any Franklin Templeton funds are currently holding CoCo bonds, a spokeswoman emailed MarketWatch, “We typically don’t comment on specific holdings.”

MarketWatch also found a Fidelity variable annuity product that disclosed it may invest in hybrid securities such as bank-contingent convertible bonds.

A Fidelity spokesman, when asked about specific CoCo holdings, said that it does not provide aggregate data or comment on specific issuers.

Calamos and Eli Pars have been warning about CoCos, even those held in a diversified fund focused on a convertible strategy, for a while. Back in 2014, Pars called CoCos “Bizarro” convertibles. “If things go well, you just get your fixed coupon and par back at maturity. But if things go poorly, you quite likely will get little to nothing in return,” wrote Pars. “After all, if a bank is in bad enough shape that its CoCos convert into equities, that bank stock you are getting may not be worth much.”

That’s exactly what happened last summer.

In June another CoCo issuer, Spanish lender Banco Popular, collapsed and was acquired by rival Spanish bank Santander for €1. Popular’s equity and CoCo bondholders lost everything. Its CoCo bonds were still trading at about half their face value until they suddenly became worthless. That was the first time losses, €1.25 billion, were imposed on CoCo bondholders, but it may not be the last.

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