Some banks will struggle to issue a form of risky bonds used to bolster their capital and others will pay a much higher price for them after similar debt held by Credit Suisse was wiped out in its forced sale, investors have warned.
Swiss regulators’ decision to write down $17bn worth of Credit Suisse’s additional tier 1 bonds as part of the bank’s purchase by UBS rather than wipe out shareholders has called into question the future viability of the $260bn segment of debt markets.
Greg Peters, co-chief investment officer of PGIM fixed income, said the fallout from the decision for banks “forever impairs the ability to issue AT1s”. “There will be a continued risk premium repricing in that space.”
Stephen Ehrenberg, a portfolio manager for Barings’ investment-grade fixed income group, warned that higher costs could well lead to a segmented market.
“You could see some of the strong UK banks and the Nordic banks continue to be able to access that market,” he said. “But you could see some of the weaker banks find that either they can’t access new issue or that the cost of doing so is too expensive.”
In a sign of smaller banks choosing not to refinance at higher rates, Deutsche Pfandbriefbank, a lender that specialises in real estate lending, decided not to call its AT1 bond last week, citing “market conditions and economic costs”.
Kian Abouhossein, European banking analyst at JPMorgan, noted recently that most banks were paying 8-10 per cent coupons for AT1 bonds but should brace for this “potentially rising into double digits”.
If they find themselves effectively locked out of the market for AT1 bonds, some banks could be forced to rely more heavily on other sources of capital, such as equity, in order to meet regulatory requirements.
Mark Holman, co-founder of TwentyFour Asset Management, said he did “not expect anybody to issue at current levels”. “I don’t see why they would pay that much when they can grow equity in other ways such as through retained earnings.”
Some banks have issued AT1 bonds at less than 4 per cent coupon recently. “Looking at the underlying risks, that just doesn’t make sense,” said Rob Thomas, a credit research analyst at T Rowe Price.
AT1 bonds are a product of the global financial crisis, born out of regulators’ desire for banks to shift risk away from depositors, and to have greater capital requirements in case of failure.
Also known as contingent convertibles, or Cocos, the bonds can be converted into equity if capital ratios slide below a certain level, or written down entirely. Investors typically earn high interest in return for bearing these risks.
The bonds form part of a bank’s tier one capital, which is the core measure of a lender’s financial strength and also comprises Common Equity Tier 1 capital. CET1 and AT1 capital must comprise more than 6 per cent of a bank’s risk-weighted assets under Basel regulations. Tier 2 capital is the second layer of a bank’s capital and comprises assets such as hybrid debt.
While debt typically ranks above equity in a restructuring, Swiss financial regulator Finma upended the order of priority by giving SFr3bn ($3.2bn) back to Credit Suisse shareholders while wiping out AT1 bondholders. Joost Beaumont, head of bank research at ABN Amro, said the decision “will definitely leave its mark on the AT1 instruments”, adding: “I definitely think it will increase the cost of capital for banks.”
AT1 bonds are perpetual, meaning the borrower has no obligation to repay investors. However, banks typically refinance the bonds with new issuance once an initial “non-call period” has expired — giving valuable flexibility to investors who can decide whether to invest in the new debt.
More than $37bn worth of AT1 debt issued globally has call dates in April alone, according to Refinitiv data. If lots of banks decide not to call their debt, yields in the AT1 market could be driven even higher, analysts say.
An Invesco exchange traded fund tracking AT1 debt has fallen 19 per cent this month, underscoring the loss of confidence in the market.
“In the short term we’re suffering from contagion and we’re suffering from a confidence issue,” said Holman.
Reassurances from other European authorities that they would not follow in Finma’s footsteps have provided little comfort. On Tuesday, Bank of England governor Andrew Bailey distanced the UK from the Swiss actions, saying: “In any resolution, we will always abide by the creditor hierarchy because that’s a cardinal principle.”
The European Central Bank previously said “common equity instruments are the first ones to absorb losses”.
With their statement, EU regulators “really wanted to show in Europe this will never, ever happen . . . But then the question is, will investors really believe this?” asked Beaumont.
One person involved in negotiating the Credit Suisse deal for UBS said the Swiss decision to change the rules was “rushed out to avoid a [winding- down of the Credit Suisse] and massive global contagion”. They added: “The AT1 market will reprice and we will pay a higher price for a while . . . At the moment, we are well capitalised and well buffered and we’ll be OK.”
Ehrenberg agreed it would take time for the market to settle. “People come away from something like this and say ‘yeah, we’ve got these rules, but over a weekend a government can change the rules’. So I think there will be a need to regain some of that trust.”
Additional reporting by Laura Noonan