Explainer: What’s an AT1 bond – and why are Credit Suisse’s now worthless?
UBS’ rescue deal of Credit Suisse, which will see it buy its stricken Zurich rival at a discount £3bn price, has come with a surprise for holders of Credit Suisse’s AT1 bonds.
These risky bonds – which had a nominal value of $17bn – are now precisely worthless.
Unsurprisingly, holders of the bonds are less than thrilled.
“It’s stunning and hard to understand how they can reverse the hierarchy between AT1 holders and shareholders,” said Jerome Legras, head of research at Axiom Alternative Investments, an investor in Credit Suisse’s AT1 debt, in an interview with Reuters last night.
But what are they – and why were they wiped out?
What’s an AT1 bond – and why is it known as a CoCo?
An AT1 bond is essentially a bond with insurance – with it being converted into equity if a bank falls below a certain, pre-decided strength or capital limit. They’re a creation of post-financial crisis reforms and help a bank to meet capital requirements.
AT1s are also known as Contingent Convertibles – hence the nickname CoCo – and were designed in part to make it less likely that in the case of a bank failure, the taxpayer would have to step in with a bailout.
They are perpetual and non-redeemable, and as part of the contract, bondholders agree to the possibility of them being written down to zero in extraordinary circumstances.
Why would you invest in them?
Because of the high premium. Banks issue the AT1s with a high yield, in part because they have confidence that they won’t need to turn them into equity – which would only happen in a scenario where the bank became significantly weaker – and because you wouldn’t be able to sell the bonds with all their associated risk without a chunky reward.
What happened this weekend?
AT1 bondholders, like all creditors, are higher in the ‘food chain’ than shareholders if a bank goes pop. In theory at least, AT1 bondholders should have expected to be compensated or take equity in Credit Suisse – therefore giving them part of the payout from UBS.
However, Swiss regulators appear to have decided that it was possible to use their extraordinary powers to effectively wipe out AT1 bondholders, with UBS paying shareholders and the bondholders left with thin air. It’s not necessarily the write down of AT1 bondholders that’s at issue – it’s the fact shareholders have jumped the traditional queue.
“This just makes no sense,” said Patrik Kauffmann, a portfolio manager at Aquila Asset Management, in an interview with Fortune. “This will be a total blow to the AT1 market. You can quote me on that.”
Chair Marlene Amstad said FINMA, the Swiss financial regulator, had used the “too-big-to-fail” banking framework to make the decision – which it says will leave the bank in a healthier state.
There is some precedent – holders of these risky bonds were also wiped out in a Portuguese bank rescue several years ago.
What does that mean for other banks and bondholders?
Unsurprisingly, holders of AT1 bonds in other banks will be more nervous than they had been about the possibility of being zero’ed in another bank collapse – likely forcing banks to up the premium on them even further to compensate for the risks.
Is there a risk of contagion in the credit market?
Short answer, yes. For the reasons above, the price of these bonds is likely to sink today – as we’ve seen in Asia.
“For equity holders to get “something” and CoCo bond holders to get “nothing” raises serious questions about the real value of CoCo bonds,” says Charles-Henry Monchau, chief investment officer at Syz Bank.
“This is creating contagion risks on CoCos. There is also a risk of spillover effect on global credit (although we note that senior secured bonds seem quite resilient including CS senior secured bonds which are jumping in price this morning),” he continued.
How will this end?
Lawyers. Always lawyers.