THE HASTE at which the purchase of Credit Suisse, a Swiss bank, by UBS, its great rival, was arranged left investors scrambling to understand the deal. One consequence is causing particular pain. The decision to write down around SFr16bn ($17bn) in Additional-Tier 1 (AT1) bonds issued by Credit Suisse has evoked fury from investors. It could even spell the end of the asset class. What are AT1 bonds?
AT1 securities are a form of “contingent-convertible” bonds created after the global financial crisis of 2007-09 to prevent the need for government-funded bail-outs of precarious banks. Cocos, as these instruments are known, are a hybrid of bank equity (the money invested by shareholders, which absorbs any losses in the first instance) and debt (which must be repaid unless a bank runs out of equity). In good times, they act like relatively high-yield bonds. When things go sour, and trigger points are reached—such as a bank’s capital falling below certain levels relative to assets—the bonds convert to equity, cutting the bank’s debt and absorbing losses. The market for AT1s is worth around $275bn. Private banks in Asia have historically been keen buyers, snapping up issuances for their ultra-wealthy clients. As recently as January, Union Bancaire Privée, a Swiss private bank, argued that the high yield on cocos made them an attractive investment in the context of strong balance-sheets at European banks.
When a business collapses a pre-arranged agreement defines how different sorts of investors will be treated. In the case of banks which issue AT1s it is generally understood that senior bondholders have a right to payouts first, followed by more junior bondholders, and those who hold AT1 bonds. Stockholders should, in theory, take the first losses. When Banco Popular, a mid-sized Spanish lender, failed in 2017, it took about $1.4bn of AT1 bonds with it and shareholders were also wiped out. The write-down of Credit Suisse’s cocos was more than ten times larger, making it the largest in history. But the real damage caused to the market was in upending the expected pecking order and placing stockholders above AT1 bondholders. Credit Suisse’s debt-issuance documents seem to allow for this, noting that AT1 bond buyers have waived any right to reimbursement in a “write-down event”. This was confirmed on March 19th.
Yet the idea that stockholders may be left with something and coco holders with nothing is contrary to the understanding many buyers had about what they were purchasing: a hybrid security somewhere between stocks and debt in the stack of capital. The revelation has already hurt the price of AT1 bonds issued by other banks. Commentary about the future of the asset class ranges from bleak to apocalyptic. Goldman Sachs warned that it has now become difficult to assess the attractive-looking spread between yields on AT1 bonds and different forms of high-yield credit, owing to a lack of clarity about how future resolutions would work. Louis-Vincent Gave, co-founder of Gavekal, a research firm said that “The terms of the Credit Suisse take-under is likely to kill the coco market.”
Cocos have faced criticism before and survived. In 2016 the market kept going despite a near-death experience for AT1 bonds issued by Deutsche Bank, when it was unclear if the German lender would be able to make interest payments. This time the bonds’ survival chances could be boosted by a statement by euro-zone regulators on March 20th saying that under their watch AT1 bonds would be written down only after common-equity instruments absorbed losses. Yet investors now have reason to doubt such claims. And if coco buyers feel they have been burned, they will be less likely to return to the market. ■
