As of: 03/21/2023 4:14 p.m
With the emergency takeover by UBS, Credit Suisse’s so-called “CoCo-Bonds” became worthless over the weekend. What are these bonds and what are the consequences of their default?
The rigorous approach taken by the Swiss supervisors in the emergency rescue of the major bank Credit Suisse was able to calm the financial markets overall. Since then, however, one sub-market has been in turmoil. This is the still relatively young market for so-called additional tier 1 bonds, also known as “CoCo bonds”.
Credit Suisse had issued such AT1 bonds with a volume of 15.8 billion Swiss francs. These were declared worthless at the weekend by the Swiss financial regulator Finma with the stroke of a pen.
New instrument of risk distribution
It was a thunderclap for the market, which is worth around 250 billion euros. Nevertheless, AT1 bonds are less a new trouble spot than a new type of risk distribution instrument. They were developed after the 2007/2008 financial crisis to make banks more resilient.
By issuing these bonds, institutions can raise capital that is almost as good as equity and counts as “Additional Tier 1” capital. This strengthens balance sheets and helps banks to meet increased equity requirements. The additional capital acts as a risk buffer. Because CoCo bonds are a special type of so-called convertible bonds (“contingent convertibles”), which must be converted into shares or written off if a bank’s key figures fall below certain thresholds.
Taxpayers should bear less of the burden
The possible forced conversion into equity will make the banks more resilient to crises – albeit at the expense of the bondholders, who will be worse off in the event of a crisis if they become shareholders as a result of the conversion. Since they are always subordinate to other bondholders, these papers are also classified as subordinated bonds.
In the extreme case of a bank collapse, the value can be written off completely. It also means that some of the bailout costs will be shifted from taxpayers to bond investors.
The market is paralyzed
A large part of the creditors might not have been aware of this enormous risk – especially private investors who were looking for higher returns on the new asset class. There was already a total write-off of AT1 bonds when the Spanish Banco Popular was taken over by Banco Santander in 2017. At that time, however, the shareholders also went away empty-handed. In the case of Credit Suisse, on the other hand, the creditors of a subordinated bond were worse off than the shareholders for the first time.
This precedent plunged the AT1 market into violent turmoil. While German banks rushed to announce that they held little or no Credit Suisse AT1 bonds, their own AT1 issuance and those of other European institutions fell sharply on Monday. The fund companies DWS, Union Investment and Deka also emphasized that they hold no or only marginal shares of these issues in their funds. In contrast, an Invesco AT1 exchange-traded bond fund (ETF) fell by up to 14 percent.
The Allianz fund subsidiary Pimco allegedly lost 340 million dollars with the AT1 papers from Credit Suisse. The respected US bond investor is said to have compensated for these losses through the price gains of its normal Credit Suisse bonds, which gained significantly in value in the course of the forced merger with UBS. Many other investors may not have had this opportunity to absorb the risk.
Even if the situation calmed down today and the first investors got back in, the loss of confidence in the market weighs heavily. New issues are currently unthinkable under these circumstances – a possible burden for the financial sector. JPMorgan analysts Kian Abouhossein and Amit Ranjan commented that Finma’s actions will generally make refinancing and capital costs more expensive for European institutions. Most banks recently offered investors between eight and ten percent interest for such bonds. But buyers are now likely to demand a higher risk premium, according to the analysts. This will increase cost pressure and the banks’ financing structure will be viewed more critically overall.
financial supervisor concerned
The dramatic development has also called the financial institutions of the EU into action. The banking supervisors of the European Central Bank (ECB), the EU bank resolution authority and the EU banking regulator EBA emphasized on Monday that real equity is normally used first to compensate for losses. AT1 capital is only the turn when the equity has been used up. This will also be the case for future crisis interventions, it said, deliberately different from the procedure in Switzerland.
“Additional Tier 1 is and will remain an important building block in the capital structure of European banks,” the supervisors emphasized in the joint statement.
Investors are outraged
Many investors reacted with outrage to Finma’s actions. “Bizarre, strange parallel world in which shareholders get something and hybrid bondholders get nothing,” railed John Likos of bond advisor BondAdviser. “Unabashedly flipping the hierarchy of capital will have consequences,” wrote Neil Wilson, chief analyst at online brokerage Markets.com.
Even former Portuguese ECB Vice President Vitor Constancio tweeted that the Swiss authorities had made a mistake that would have consequences and potentially many court cases. In fact, the first investors are said to be preparing lawsuits against Switzerland.