AT1/CoCos: Can the stellar performance continue?

The central banks of Europe and the UK have been cutting rates over the past few months in response to softening inflation and tepid growth. Markets are pricing in more reductions this year, making some investors wonder about what the macro environment means for contingent convertible bonds.

It’s well understood that the earnings potential of banks tends to increase in a rising interest rate environment, which typically happens when an economy is in a robust shape. In that scenario, the demand for credit is typically high and banks can lend at higher rates, and that in turn boosts Net Interest Margins (NIM). The converse too can still represent a favourable environment for investors in CoCos.

Last year was a strong year for subordinated financial bonds, with credit spreads tightening sharply. The windfall followed aggressive rate increases by central banks in the developed world to quell a post-Covid surge in inflation. CoCos performed strongly after the strong widening in credit spreads seen in 2023 due to the turbulence faced by US regional banks and the collapse of Credit Suisse.

Since spreads are already at multi-year tights, we believe the room for further compression is limited. Even so, CoCos continue to be an attractive opportunity for fixed income investors on the back of solid fundamentals, higher yields and elevated “carry” when compared to most other credit market segments, including high yield corporate bonds.

Yield comparison across fixed income

Although AT1s are the most subordinated form of bank debt, most of the instruments are rated either "BBB’’ or "BB’’ but still yield more than many "single B’’ rated corporate bonds. The fact that almost every issuer is rated `investment grade’ can boost the desirability of CoCos.

While rate cuts could translate into moderately lower NIM for banks, affecting their distribution capacity, it’s important to remember that the capital position of European and UK lenders is very solid, just off the peak reached in the last two years. Such large capital buffer should help to absorb the aforementioned reduction in NIM without too much trouble. Importantly, lower interest rates could also ease any pressure of defaults by borrowers which would see the interest of their loans reducing as rates go down.

In addition, the CoCos supply outlook is favourable this year as banks in Europe and the UK had frontloaded much of their financing activity in 2024. Coupled with slightly higher redemptions in 2025, total yearly net issuance is expected to be much lower than that of 2024. Furthermore, coupons on CoCos have risen along with the rise in policy rates after Covid, which provides a cushion and underpins total returns. This environment contrasts with the decade that followed the GFC, where risk-free rates mostly hugged zero.

CoCos could also help investors to navigate elevated uncertainty stemming from US President Donald Trump’s policies such as imposing reciprocal tariffs on trading partners, which could prove to be inflationary and eventually hurt growth. This could lead to volatility in the rates market and pose some risks to long duration segments of the bond market, including senior bank debt or long dated corporate bonds. CoCos, on the other hand, thanks to the much lower duration, should be more insulated from this risk. Furthermore, such instruments issued by European banks remain attractive when compared to the very expensive valuations of US banks especially preference shares and more generally at subordinated bond level.

As an instrument introduced after the Global Financial Crisis to boost the capital ratios of banks, CoCos have provided very attractive returns with lower volatility than bank equity indices over the past decade. The instruments also offer higher yields than most fixed income sectors. However, being risk aware is important to avoid any downside risk. In the current volatile global environment, marked by geopolitical tensions and policy uncertainty, credit selection through rigorous fundamental analysis is key for effective alpha generation. And we believe our deep expertise as active managers could play an important role in managing the unfolding scenario in the coming months.

Strategy specific risks

• Currency (FX) Risk - The Strategy can be exposed to different currencies and movements in foreign exchange rates can cause the value of investments to fall as well as rise.
• Share Class Hedging Risk - The share class hedging process can cause the value of investments to fall due to market movements, rebalancing considerations and, in extreme circumstances, default by the counterparty providing the hedging contract.
• Interest Rate Risk - The Strategy can invest in assets whose value is sensitive to changes in interest rates (for example bonds) meaning that the value of these investments may fluctuate significantly with movement in interest rates.e.g. the value of a bond tends to decrease when interest rates rise
• Pricing Risk - Price movements in financial assets mean the value of assets can fall as well as rise, with this risk typically amplified in more volatile market conditions.
• Contingent convertible bonds - The Strategy may invest in contingent convertible bonds. These instruments may experience material losses based on certain trigger events. Specifically these triggers may result in a partial or total loss of value, or the investments may be converted into equity, both of which are likely to entail significant losses.
• Credit Risk - The issuer of a bond or a similar investment within the Fund may not pay income or repay capital to the Fund when due.
• Market Concentration Risk (Sector) - Investing in a particular sector can cause the value of this investment to rise or fall more relative to investments whose focus is spread more evenly across sectors.
• Derivative risk - the Strategy may use derivatives to generate returns and/or to reduce costs and the overall risk of the Strategy. Using derivatives can involve a higher level of risk. A small movement in the price of an underlying investment may result in a disproportionately large movement in the price of the derivative investment.
• Liquidity Risk (general) - During difficult market conditions there may not be enough investors to buy and sell certain investments. This may have an impact on the value of the Fund.
• Counterparty Default Risk - The risk of losses due to the default of a counterparty on a derivatives contract or a custodian that is safeguarding the Strategy's assets.
• Sub investment grade bonds - The Strategy may invest a significant portion of its assets in securities which are those rated below investment grade by a credit rating agency. They are considered to have a greater risk of loss of capital or failing to meet their income payment obligations than higher rated investment grade bonds.
• Charges from capital - Some or all of the Strategy’s charges are taken from capital. Should there not be sufficient capital growth in the Strategy this may cause capital erosion.

Important information

This document is intended for investment professionals and is not for the use or benefit of other persons. This document is for informational purposes only and is not investment advice. Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested. The views expressed are those of the individuals mentioned at the time of writing, are not necessarily those of Jupiter as a whole, and may be subject to change. This is particularly true during periods of rapidly changing market circumstances. Every effort is made to ensure the accuracy of the information, but no assurance or warranties are given. Holding examples are for illustrative purposes only and are not a recommendation to buy or sell. Issued in the UK by Jupiter Asset Management Limited (JAM), registered address: The Zig Zag Building, 70 Victoria Street, London, SW1E 6SQ is authorised and regulated by the Financial Conduct Authority. Issued in the EU by Jupiter Asset Management International S.A. (JAMI), registered address: 5, Rue Heienhaff, Senningerberg L-1736, Luxembourg which is authorised and regulated by the Commission de Surveillance du Secteur Financier. No part of this document may be reproduced in any manner without the prior permission of JAM/JAMI/JAM HK.