Bond investors woke up with a big problem on Monday. Sunday’s emergency takeover of struggling Swiss bank Credit Suisse by its rival UBS deepened a rout in AT1 bonds. These instruments are designed to be wiped out when an issuing bank hits financial trouble, reducing its debts.
Swiss regulators obliterated about $17bn of Credit Suisse AT1s on Sunday, as local rules evidently allow. That triggered drops in other European and Asian AT1s, which had begun falling heavily last week.
AT1s, which are sometimes classed as contingent convertibles or “Cocos”, are senior to equity but junior to other debt instruments in the capital stack. Coupons are correspondingly higher.
Owners of Credit Suisse bonds are furious because UBS will pay equity investors $3bn for their shares in UBS stock. This is a fraction of Credit Suisse’s recent market worth, but a payout nevertheless.
But because Credit Suisse was taken over, rather than filed for bankruptcy, these arguments may not hold up in court. Triggers for voiding AT1 bonds differ by country and according to individual terms.
The European Central Bank and other EU regulators pointed this out in a statement that criticised the Swiss authorities and attempted to calm investors.
Their confidence in this $275bn market has taken a blow, even so. The perpetual notes of important lenders in Asia, including Hong Kong’s Bank of East Asia and Thailand’s Kasikornbank, fell to about 80 cents to the dollar, levels rarely seen for these banks.
Prices for European AT1s were lower in some cases. On Monday morning, instruments issued by UBS were at 84 cents but Deutsche Bank and BNP Paribas were at about 70 cents on the dollar.
AT1s were initially seized on by Asian hedge funds, who saw them as offering high returns at low risk. But the yields — for many banks almost double that of senior debt — have attracted more funds from institutional and retail investors in Asia in recent years.
The impact of the AT1 rout will be biggest in Europe. European issuers account for more than 80 per cent of the total market. Almost all of them are lenders, the rest are insurance companies.
AT1s have helped them fulfil regulatory capital requirements. But the current rout raises awkward questions about how useful they are as capital buffers. If national financial authorities can wipe them out before equity, investors will have to price AT1s accordingly. They would then trade on yields that would be prohibitively high for issuers.
One obvious conclusion would be that investors who read AT1 small print carefully should find some bargains. But a problem remains: financial authorities may override contractual small print in future, even if Swiss watchdogs did not do so in this case.