Where can an investor find high yield from investment grade issuers? Sounds unlikely doesn’t it, particularly in a world of quantitative easing where central banks are deliberately keeping yields on nearly all bonds at record low levels.

But there is a niche where the central banks do not go. Bonds issued by banks are ineligible for the corporate bond buying program and so their yields are less disturbed than for other corporate bonds. Within bank bonds there is a class of bond called Additional Tier 1 (AT1), or more colloquially CoCo. These bonds form part of the capital base of banks and are viewed by some investors as being highly risky. As a result the bonds have high yields, typically in the 5% region. It is indeed true that in the event that a bank finds itself in serious distress, requiring resolution (the new administration process for failing banks), then the bonds would in all likelihood be valueless. But that would also be true for the shares in the bank and also its Tier 2 bonds and probably its no-preferred senior bonds too. But is that really any different from investing in the bonds of any other type of business? So the key here is to invest only in the very highest quality banks where this outcome is very remote.

One of the reasons we feel very comfortable in investing in these CoCos is that bank balance sheets have changed since the Global Financial Crisis. Gone are the structured assets that proved so toxic to be replaced with more straightforward loans and bonds. But the biggest change, and the one that makes all the difference to CoCo holders, is that equity has increased many fold. Equity is the part of the bank that belongs to shareholders, and it is the first in line to bear pain if the bank makes a loss. Bank equity levels today, as measured by the Core Equity Tier 1 ratio, are multiples of what they were, and are able to withstand the enormous losses that regulators test them with each year in the annual Stress Tests. It is this equity that acts as protection for both the bank’s depositors but also its bondholders, including CoCo bondholders.

A second reason is that when dividend payments from banks were stopped during 2020, explicitly European regulators stated that payments to CoCo holders should continue uninterrupted. This support for the asset class from regulators is very important.

Through thorough analysis we are able to put together a diversified portfolio of these CoCos, from the finest quality issuers, giving the Premier Miton Financial Capital Securities Fund a yield above 4.5%.

So high yield from investment grade issuers.

Rob James Fund Manager