Coco bond contagion contained after Banco Popular wipeout

The market for the riskiest type of bank debt rallied on Wednesday, as the complete writedown of such bonds at Spanish lender Banco Popular failed to rattle an asset class that has proved volatile in recent years.

The sudden collapse in the value of Banco Popular’s bonds has been dramatic. Its now worthless €1.25bn of Additional Tier 1 bonds were still trading at about half of face value before the bank’s resolution and takeover by rival Santander was announced on Wednesday morning. This is the first time losses have been imposed on AT1 bondholders.

However, the wipeout had little spillover into the rest of the market, with most other AT1 securities soon trading at higher levels — even for debt issued by Spanish banks. By midday on Wednesday, CaixaBank’s recently issued €1bn 6.75 per cent note was trading about a point higher than the previous day’s closing price.

“I think this is actually very positive for the AT1 space — the market has now been tested and the contagion is almost non-existent,” said Marc Stacey, a portfolio manager at BlueBay. “This is exactly what these instruments are designed to do; the regulator has been clear that if things go wrong, you will see haircuts.”

Additional tier 1 bonds count towards banks’ capital ratios and were designed as part of a global regulatory shift to shore up lenders’ balance sheets after the financial crisis, while ensuring that bondholders, and not taxpayers, would bear the brunt of bank failure.

The bonds are more colloquially referred to as cocos, in reference to the fact that many have “contingent convertible” features — triggers that convert the bonds into equity when a bank’s capital ratio falls below a certain level.

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The calm on Wednesday stands in stark contrast to the chaos in the market just over a year ago. In February 2016 jitters around whether Deutsche Bank could continue to pay coupons on its AT1s triggered a broad sell-off, closing the primary market for such securities entirely.

Spanish banks have continued to print AT1 bonds in recent weeks, however, with bond buyers shrugging off the escalating concerns around Banco Popular. CaixaBank issued its €1bn note last Thursday, drawing €3bn of orders even though Popular’s bonds and equity dropped to further lows the same day.

“If a second tier Spanish or Italian bank came to market they might face a bit of investor apathy, but those aren’t the types of issuers that are really looking to access the market, and for everyone else it’s irrelevant,” said Piers Ronan, head of financial institutions debt syndicate at Credit Suisse.

While the EU’s new bank rescue agency imposed losses on additional tier 1 and tier 2 bonds, holders of Banco Popular’s senior debt were left unscathed. Pieter Fyfer, a credit strategist at Credit Suisse, said this was one of the reasons why the market rallied on Wednesday.

“If we’d seen senior included in the bail-in, the repercussions might have been slightly different,” he said.

Several investors said the losses imposed on tier 2 bondholders, who saw their debt converted into equity that Santander then purchased for just one euro, served as a reminder that risks lie beyond just AT1 securities.

Tier 2 bonds are higher up in the pecking order and, unlike AT1 bonds, have a fixed maturity date and cannot skip coupon payments. But they are still exposed to losses if a bank collapses.

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“When banks are bailed in, your losses are going to be so high that structural features like triggers, equity conversions and writedowns really aren’t going to make any difference,” said Chris Telfer, a portfolio manager at ECM Asset Management.

“The difference in the amount of losses needed for one coco to get triggered versus another coco, or even for the cocos to get triggered versus the Tier 2, is so narrow and regulators are always going to err on the side of caution.”

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