Old Mutual fund manager Rob James is backing contingent convertible bonds to tap into what he said is the opportunity in the banking sector.
Mr James, who jointly runs the £162m Old Mutual Financials Contingent Capital fund, said banks have “changed” since the financial crisis, and Coco bonds represent the best opportunity for fixed income investors to access their recovery.
Mr James said the size of the convertible bond market is such that he hopes the fund can grow to "many billions" in size, especially as there are few other funds doing the same thing.
Contingent convertible (CoCo) bonds are fixed income investments that will convert to shares in the event of certain financial conditions arising.
In the global financial crisis, when banks were bailed out by taxpayers, this was because bond holders had, in the view of policy makers, to be paid for the bonds they owned. By comparison, the owners of the equity (shares) received nothing.
In the event of another banking crisis, these particular bonds could turn into shares, and so not be bailed out.
Due to their more risky nature, the Financial Conduct Authority (FCA) has previously said CoCo bonds are not suitable to be sold direct to retail investors. Mr James's fund, which launched in August and has a current yield of 5.8 per cent, is only available to investors via financial advisers.
He said regulators have made it clear some of the more conventional bonds issued by banks would also not be bailed out in the event of a crisis, yet the yield on the CoCo bonds is higher than on the conventional bonds.
Mr James's background is as a banks equity analyst, and he has previously run equity funds. His co-manager on this fund is Lloyd Harris, a fixed income fund manager at Old Mutual Global Investors.
Under regulations introduced since the financial crisis, banks are required to hold a certain proportion of their balance sheet in liquid assets, such as cash.
This proportion is currently around 13 per cent. Mr James said Coco bonds typically turn into equities if a bank is reduced to having 7 per cent or less of its balance sheet in lower risk assets.
This drop can happen if the liabilities of the bank grow rapidly, as might happen in a financial crisis, or if a bank cannot raise capital in other ways, such as from shareholders.
The fund manager argued the key to the investment case for CoCos is that when they were conceived, banks expected the level of capital they were required to hold to be in the area of 10 per cent, with the bonds turning to equity at 7 per cent.
The reduced margin of error meant that the first CoCo bonds that come to market came with yield reflecting that level of risk, and the yields haven’t changed even as the required level of capital has altered.
