Deal would write down more than $17 billion of the bank’s riskiest bonds
By Matt WirzFollow
, Caitlin McCabeFollow
and Anna HirtensteinFollow
Updated March 20, 2023 9:54 am ET
Credit Suisse Group AG’s CS -4.71% emergency merger with UBS Group AG UBS -6.03% decrease will wipe out the bank’s riskiest bonds, rattling investors in the quarter-trillion-dollar market for similar bank debt.
About 16 billion Swiss francs, or about $17.3 billion, of the bank’s additional tier 1 bonds will be completely written down, Switzerland’s financial regulator, Finma, said in a Sunday statement. Credit Suisse also said it was informed by Finma that the bonds would be “written off to zero.”
European and Asian AT1s fell Monday with one of the bonds issued by HSBC Holdings PLC HSBC -2.39% decrease; dropping 8% to 88 cents on the dollar in heavy trading. A roughly $1 billion AT1 exchange-traded fund from Invesco dropped 8.7%, while a similar ETF from WisdomTree slid 6.3% in recent trading.
UBS AT1s with a 2025 call fell Monday to around 85 cents on the dollar compared with 93 cents on Friday, according to Tradeweb.
AT1 bonds—also known as contingent convertible bonds, or CoCos—were introduced after the financial crisis as a way to transfer banking risk away from taxpayers and onto bondholders. They also became a popular investment product that money managers and banks, including Credit Suisse, marketed to clients as a relatively safe way to boost yield on bond portfolios.
European banks like to issue AT1s. Even though the interest costs are higher than traditional bonds, their bail-in features reassure regulators that the banks hold enough of a capital buffer.
That makes AT1s a less financially painful way of building up capital than issuing common equity or shares. European bank share prices have been battered for years making potential equity issuance highly dilutive to existing shareholders.
Buyers of these bonds were always risking the chance that the instruments would become worthless or written down to a fraction of their value. They are structured so that the debt can be “bailed in” under circumstances laid out in individual bond prospectuses. These can include when a company’s capital ratios fall below a certain level or if regulators deem a bank unviable. Some AT1s convert to equity, while others such as Credit Suisse’s get wiped out.
The decision to wipe out Credit Suisse’s AT1 bonds has prompted frantic questions among investors. Among them: Why were bondholders wiped out when shareholders weren’t?
“What’s shocking is that it looks like equity holders will recover better than tier 1 bondholders,” said Justin D’Ercole, co-founder of ISO-MTS Capital Management LP, a fund focused on bank securities. The resulting losses will likely prompt individual and institutional investors to sell similar securities of other European banks, he said.
Traditionally, bondholders rank above equity holders in capital structure. But the Credit Suisse bonds were outliers from other European banks, because they provided for a case where regulators could write them down without wiping out equity holders.
Regulators in the eurozone, which doesn’t include Switzerland, clarified that difference with investors Monday.
“Common equity instruments are the first ones to absorb losses, and only after their full use would Additional Tier 1 be required to be written down,” said a statement from the European Central Bank’s banking supervision arm, the Single Resolution Board and the European Banking Authority.
“This approach has been consistently applied in past cases and will continue to guide the actions [of European banking regulators] in crisis interventions,” the statement said.
Under the terms of the deal between the two Swiss banks, the AT1 holders get nothing, while equity holders get UBS shares that value Credit Suisse’s existing shares at around 0.70 Swiss francs. That is far below where they traded Friday, but still something.
“Everybody knows it’s a risky instrument, said Jérôme Legras, managing partner at Axiom Alternative Investments, a fund specializing in bank debt. “I don’t think the market would have been this stunned if everybody had zero, including shareholders.”
He said Switzerland’s decision raises questions about the country’s financial regulator, and added that he is unlikely to invest in Swiss AT1 bonds.
Even before Credit Suisse’s AT1 bonds were wiped out Sunday, cracks spread in the AT1 market last week. Deutsche Bank AG’s $1.25 billion 6% AT1 bond fell 10% last week to about 79 cents on the dollar, according to Advantage Data Inc. UBS’s $2.5 billion 7% bond dropped about 5% to 95.50 cents on the dollar, according to MarketAxess.
There are about $254 billion AT1 bonds outstanding and the securities are often banks’ most actively traded bonds because of their large size, according to data from Lazard Frères Gestion. The AT1 bonds also pay higher interest rates than traditional debt because they can be converted to stock or written down if trouble at an institution emerges, paring down its liabilities in times of crisis.
Higher yields attracted buyers for much of the past decade when benchmark interest rates were low, dragging down the yield of most bonds.
“The CoCo market offers a yield of around 3.62%,” portfolio managers in Credit Suisse’s investment unit wrote in a January 2021 report. “Even European high-yield bonds come in at around 2.88%, so we definitely still see value in subordinated financial bonds.”
Demand was hot enough in August 2020 that when Credit Suisse launched a $1.5 billion AT1 deal with a 5.625% interest rate in August 2020, it received more orders than it had bonds and bargained the rate down to 5.25%, according to CreditSights.
“The average European bank would need to lose almost two-thirds of its capital to breach contractual triggers,” the Credit Suisse fund managers said in their 2021 marketing report. “In our view, this is a relatively remote scenario.”
Holders of CoCo bonds in Spain’s Banco Popular Español SA got wiped out in 2017 when the bank got bailed out through a merger with Banco Santander SA. Popular’s shareholders also took losses, but the restructuring was seen as an isolated event.
The bulk of the bonds are held by insurers and pensions or are sold to individual investors outside of Europe through investment funds, according to a 2017 report by De Nederlandsche Bank. European investors may also buy them indirectly through international funds, according to the report.
Invesco Ltd. launched an exchange-traded fund focused on AT1 bonds in 2018 that has grown to about $1.2 billion, according to data from Morningstar Inc. At the end of January, AT1 bonds issued by Deutsche and UBS were the two largest investments in a $4.5 billion Nuveen Asset Management mutual fund specializing in preferred securities, according to Morningstar.
The complete write-off by Credit Suisse, one of the largest issuers in the AT1 market, will likely hurt investor appetite for the bonds, fund managers said. It will also squeeze lending by banks, they said.
Ultimately, AT1 bonds will become more expensive for banks to issue, reducing their ability to make new loans, Mr. D’Ercole said. “That means banks will likely have to run smaller balance sheets,” he said.
Caitlin Ostroff contributed to this article.
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