ADDING bonds consistently to your portfolio is a way to prepare yourself for retirement as bonds provide a steady source of income.

A type of bond that you should consider adding to your bond portfolio is a Contingent Convertible Bond (CoCo) because they typically offer higher coupons (income) than other bonds. CoCos are complex financial instruments with unique characteristics and special terms and conditions that differentiate them from traditional bonds, offering both potential benefits and risks to investors. The higher coupon is a way to attract investors who are willing to navigate this complexity in exchange for the potentially greater returns.

CoCos are issued by financial institutions and redesigned to absorb losses and help them to maintain their capital ratios during periods of financial stress. The defining feature of CoCos is their ability to be converted into equity or be written down when a predefined trigger event occurs. These triggers are typically tied to the issuer’s capital adequacy ratios, such as the Common Equity Tier 1 (CET1) ratio. If a bank’s CET1 ratio falls below a certain threshold, the CoCos automatically convert into equity or the bond’s principal is written down, providing immediate capital relief to the bank.

CoCos can be classified into two main types, based on their conversion triggers: mechanical and discretionary. Mechanical triggers are automatic and occur when specific financial metrics are breached, while discretionary triggers depend on regulatory decisions.

In addition to offering higher coupons and higher yield compared to traditional bonds, CoCos are a valuable addition to a bond portfolio because they add diversification. CoCos have a different risk-return profile compared to other fixed-income securities, potentially improving the portfolio’s risk-adjusted returns. They are influenced by factors affecting the banking sector, which might not impact other sectors in the same way.

There is also the potential for capital gains. CoCos can provide capital gains if the issuing bank performs well and the perceived risk of conversion decreases. This can lead to an appreciation in the bond’s market price.

Another reason to consider adding CoCos to your bond portfolio is that CoCos are often viewed favourably by regulators as they help banks shore up their capital, without diluting the holdings of existing shareholders until absolutely necessary. This regulatory backing can provide an additional layer of confidence to investors.

While CoCos offer attractive benefits, they come with certain risks. The primary risk is the potential for conversion into equity or a write-down of the bond’s principal, which can result in significant losses for bondholders. Additionally, the complex nature of CoCos means that investors must thoroughly understand the specific terms and conditions of each bond.

In conclusion, Contingent Convertible Bonds can be a valuable addition to a bond portfolio, providing higher yields, diversification benefits, and the potential for capital gains. However, investors should carefully weigh these advantages against the inherent risks and ensure they have a comprehensive understanding of the terms and triggers associated with these instruments. As with any investment, a well-thought-out strategy and diversification are key to managing risks and maximising returns.

Toni-Ann Neita-Elliott, CFP, is vice-president marketing and sales at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm

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