The UK’s bank regulator recently banned British banks from mass marketing a new type of hybrid debt instrument to retail investors, but that hasn’t stopped institutional investors from piling in. These new securities known as contingent convertible bonds, or CoCos for short, are designed to help banks bolster their capital positions and provide higher levels of protection for taxpayers in case of another credit crisis like we saw a few years ago. While the yields offered on CoCo bonds were quite enticing when they first came out, their expected returns have since dropped substantially leaving investors little room for error if Europe falls back into recession.

CoCo bonds are classified as ‘hybrid securities’ because they possess attributes of both stocks and bonds. When the financial sector is running smoothly, Cocos typically behave like other fixed-income securities, trading up or down based upon prevailing interest rate levels and the outlook for the credit markets. In the meantime, these bonds provide a relatively high level of current income which is designed to compensate investors for what is likely a higher degree of risk than other obligations contained within a bank’s capital structure.

In terms of cash flow, income is accrued daily and interest payments are usually made like conventional bonds. Interest payments on CoCos are not subject to withholding at source to offshore investors but the final maturity on most of these bonds is very long term and often perpetual, meaning that the bond never really matures. The far reaching maturity dates, or long ‘durations’, in financial industry parlance, means that prices fluctuates greatly based upon prevailing interest rate levels.

While CoCos act like typical long term bonds when the issuer is stable, that can change dramatically. In the event of a downturn, when a particular financial institution finds itself in trouble, the CoCo bonds can immediately become more equity-like, usually absorbing the first losses. Each issue is different, but in general when a bank’s financial position reaches a critical trigger point the bonds convert into stock and may lose some or all of their value. A typical trigger event would be a bank falling below a specified capital level.

Despite the risky nature of these assets, regulators have allowed them to be issued in limited amounts and count towards bank equity in meeting news rules for higher capital levels required under Basel III, a sweeping bank reform act. The Basel III rules, issued after the European credit crisis, were designed to place more stringent controls on banks by forcing them to maintain stronger balance sheets and other measures of capital adequacy.

While initially quite attractive, yields on CoCo bonds have steadily declined over the past few years having now been almost cut in half. The Credit Suisse contingent convertible index has fallen from a yield of over 12 per cent in 2011 to a present average of just six per cent.

Rather than buying CoCos at these levels, we prefer investing in straight preferred stock. Similar to CoCos, preferred stock issues are normally subordinated to other debt issued by the same company; however straight preferreds cannot be forced into a common stock conversion. This is a key factor as preferred stock is senior to a company’s common stock in terms of any claims on assets, a critical factor in the event a company gets into trouble. Oddly enough, many preferred issues are offering yields just below or even on par with the yield of similar Coco issues despite lesser credit risk in most cases.

Falling between the cracks of dedicated equity and fixed-income analysts, hybrid instruments tend not to be well covered and are therefore typically misunderstood by investors. Securities which are misunderstood often provide intriguing investment opportunities but only for those who do their homework.

Bryan Dooley, CFA is a senior portfolio manager at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.