FCA looks to permanently ban CoCo promotion and sales to retail investors

The promotion and sale of contingent convertibles (CoCos) to retail investors could be permanently banned under proposals from the Financial Conduct Authority (FCA), which is seeking to extend the restrictions to funds that predominantly invest in the securities.

In August, the financial watchdog announced that the promotion and sale of CoCos to retail investors would be banned for one year, starting from this month. At the time, it said the restrictions would not apply to funds.

The FCA describes CoCos as “risky, highly complex financial instruments”. The securities are similar to regular convertible bonds but differ in that the likelihood of them converting to equity is contingent on a specified event, such as the share price of a company dropping below a particular level for a certain period of time.

In essence, they are designed to act like bonds when times are good but like equities when things turn sour. By converting to shares when prices are depressed, they can provide a boost to the issuer’s capital levels and help to reassure the market.

Issuance of CoCos has been rising over recent years, with large companies putting out the bonds including Lloyds Banking Group and Barclays. It’s the banking sector which has made greatest use of the securities, as some regulators believe they could act as a buttress for a bank’s finances during times of stress.

Indeed, issuance by the banking sector has spiked over recent years. In 2010, almost no CoCos were put out; over 2014 so far, it’s reached around $65bn.

They have also caught the eyes of investors in the current low-interest world as they typically yield around 7 per cent. But the terms and conditions attached to them can vary widely, increasingly the likelihood they can be misunderstood by retail investors without specialist knowledge.

New guidance from the FCA says it is now consulting on making permanent the ban on the promotion and sale of CoCos to retails investors. Furthermore, a ban on aiming funds which “invest wholly or predominantly in CoCos” at retail investors is being considered.

The watchdog highlights a number of potential risks that could stem from CoCos, adding that it believes “ordinary retail investors are unlikely to be able to understand or evaluate these investment propositions”.

It says pricing of CoCos is challenging “even for professional investors” and demands the evaluation of complex risk factors. These include the likelihood of an issuer’s capital reserves changing over time; the extent of any losses upon trigger conversion; whether the note is permanent or dated; and any potential contagion risks should a separate issuer decide to cancel their coupon payments.

This last risk was highlighted by Royal Bank of Scotland (RBS) analysts in a note earlier this year. CoCos have yet to be tested by a severe market downturn or by a major issuer either deferring the payment of a coupon or converting the security, making it hard to judge how the whole market will react should problems arise.

After surveying holders of CoCos. RBS said: “Despite their limited concerns on volatility and liquidity, many investors appear worried about the market’s reaction to the first coupon deferral or trigger.”

“On average, investors expect a 9 per cent drop for CoCos across the board on the first deferral of coupons, and a 15 per cent drop in prices for a conversion. That said, we capped the possible answer to a 20 per cent drop upon a conversion, and it is likely that some investors may have opted for an even steeper drop if they had the option.”

Furthermore the FCA highlights the view of European Union financial regulatory institution the European Securities and Markets Authority, which says the analysis and evaluation of CoCos’ risks “can only take place within the skill and resource set of knowledgeable institutional investors”.

Most damningly, the regulator’s paper on CoCos said: “These instruments are designed to meet the capital needs of issuers. They are not investment products designed to meet the needs of investors.”

“However, CoCos tend to offer relatively high ‘coupon’ rates, which can easily catch the eye of investors, particularly in the present low interest rates environment. Ordinary retail investors are at a particular risk of inappropriate investment.”

Summing up its concerns, the regulator says it consider the securities to be primarily for the institutional market. However, it adds that while it hopes to ban their sale to retail investors, they will remain accessible to sophisticated and high net worth investors.

Furthermore, its proposed ban on funds would only apply to those that invest “wholly or predominantly in Cocos and which are not retail-oriented regulated funds”, not those which hold the bonds as part of a more mixed portfolio.

When the FCA implemented its temporary ban on CoCos, Artemis Strategic Bond fund manager James Foster explained why he is cautious on the asset class and said the watchdog is “right to be wary”.

“In good times, CoCos will perform well. But in bad times they could fall sharply, even if they are not converted into equity. So they should be treated as a (very) fair weather instrument,” he said.

Foster also argued that the normal rules for bonds are turned “on their head” when it comes to CoCos, as the bonds will be converted or written-off before equity holders suffer if something goes wrong with the issuer.

“Shareholders usually have a degree of self-interest in protecting bondholders: if the bonds suffer losses, then shareholders lose everything. In that sense, their interests are aligned. In the case of CoCos, however, it seems likely that equity holders would be keen to actively encourage their conversion into equity, helping to boost the banks’ capital cushion.”

Artemis Strategic Bond does invest in CoCos, having around 3 per cent of its portfolio in such securities in August. However, Foster would not take exposure to more than 10 per cent in them, even if their prices were to fall to more attractive levels.

The manager added: “At first glance, the FCA’s decision to ban sales of these instruments to retail investors may seem extreme. Given that the minimum lot size is £100,000, it is unlikely to have much of an impact on sales to individual investors.”

“But if the ban helps to send a signal about the hazards that accompany these types of bonds, it will have been a useful intervention: it would be wrong to allow investors to continue buying CoCos without being fully aware of the risks they involve.”