La Française: Outlook for CoCos in 2024

La Française: Outlook for CoCos in 2024

March 14, 2024

Fixed Income
Outlook vooruitzicht (14).jpg

In 2023, the CoCo market experienced the disappearance of more than 6% of its asset base, with the sudden collapse of $16bn of Credit Suisse bonds. Some predicted that it would mark the death of this market and that confidence had been broken. Yet, CoCos recovered quickly, as investors knew that Credit Suisse was a one-off event and not a looming systemic crisis.

One year later, another bank is in trouble: Deutsche Pfandbriefbank. A small and opaque German lender, solely specialized in commercial real estate lending in Europe and in the US, which is in the eye of the storm. Regardless of what may happen to this small bank, there has been no contagion to other issuers, and we do not think that there will be any. And the reason is simple: these are Darwinian events. Bad players are getting eliminated by the market and only the more robust strive.

We view this episode as comparable to what happened to Banco Popular in 2017 (full write-down of all of its subordinated debt): an idiosyncratic event which eventually led to more consolidation. That is the reason why banks have become much bigger these past 15 years: they need to build strong balance sheets and achieve a large scale to stay profitable and solvent at the same time.

The media attention that CoCos receive in the event of a default is much larger than that of any non-financial company in the High Yield market, even though the latter can and does suffer from many more failures. We actually view this stigma on the CoCo market as a good argument to buy the asset class when everybody is getting afraid of it. You know the mantra: be greedy when others are fearful, be fearful when others get greedy.

Bouts of volatility are usual in our high-beta asset classes and usually represent a good point of entry. Uncertainties around commercial real estate do not really worry us, as all systemic European banks have very manageable exposures. They shall certainly increase their provisions to cover these higher risks, but this should not weigh on their credit metrics, as their profitability has never been so good than in the past 15 years.

Relative valuations on the asset class look rosy in our opinion, even after the tremendous Q4 23 rally experienced by all fixed income segments. Yields on euro-denominated CoCos are still above 8% on average and we believe that absolute yields should prove to be a tailwind for the asset class throughout 2024.

CoCos should also benefit from (i) looser monetary policy decisions and lower rates and (ii) expectations of strong inflows within all fixed income segments and (iii) a mild recessionist macroeconomic outlook in Europe, which is very manageable for credit spreads overall. As such, we think that CoCos represent a good carry trade for 2024, along with a rate compression tailwind component that may enhance its performance.

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