Why Mom and Pop Should Be Kept Away from Banks’ Bailout Bonds

Two new ETFs will let ordinary investors buy risky bank debt, which isn’t a good idea

By Paul J. Davies

Yield to maturity on an index of Cocos* 
Source: IHS Markit

Note: *iBoxx USD Contingent Convertible Liquid Developed Market AT1 index

Banks are hard enough to understand when it comes to owning their shares. But the complexity is doubled if you invest in their risky high-yield bonds, which are designed to pay for losses in times of trouble.

Mom-and-Pop investors in most countries have been blocked from owning these technically complex securities directly, which are often known as Cocos, an abbreviation of “contingent convertible.” However, now, retail investors can buy them in two exchange-traded funds. That might be a sign that this young market is growing up. Or perhaps it is a recipe for disaster. 
European and Asian banks have issued Cocos worth billions of dollars to help shore up their balance sheets since the 2008 crisis. They are cheaper to finance than equity, but still absorb losses in times of crisis and therefore make taxpayer bailouts less likely.

Deutsche Bank’s headquarters in Frankfurt. Photo: Michael Probst/Associated Press 

However, they have been criticized for being too complicated even for institutional investors and performance has been volatile. Prices plunged in early 2016 when fears around Deutsche Bank’s Co cos and misunderstandings about how they worked sparked panic in the sector. The collapse brought a spike in yields, which reached 10.7% for the iBoxx index of the most liquid, dollar-denominated Cocos in mid-February 2016, up from 7% at the start of January. 
This index is the basis for Invesco PowerShares’ new AT1 Capital Bond ETF, which was launched last week. WisdomTree launched a similar fund in May, based on a wider, multicurrency iBoxx Coco index. Neither fund is aimed at the retail market, but anyone can buy them.

Individual investors can access lots of assets through funds they couldn’t buy directly—corporate junk bonds or emerging-markets debt, for example. However, bank capital poses more problems than just complexity when held by retail investors.

In Italy, banks were allowed to keep selling similar bonds to individual investors. That has made fixing problem banks more difficult, because politicians were fearful of imposing losses on ordinary savers.

This is the essential problem with allowing nonprofessionals near these bonds: If the bonds can’t take losses, they don’t work as capital. One bond going bad in a fund should just mean a small loss, which is fine. However, if a lot of retail money is involved during a wider crisis, taxpayers’ money will be at risk again.

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