On March 19, 2023, came the biggest shocker from the world of banking as after lengthy negotiations with the Swiss government, UBS acquired the 167-year-old investment and financial services behemoth Credit Suisse for USD 3.25 billion in order to prevent the latter’s collapse, after Saudi National Bank, Credit Suisse’s largest investor, decided against providing more financial assistance to the crisis-hit Swiss financial major.
Credit Suisse’s monetary outflows topped 10 billion Swiss francs after March 15, 2023, when the bank’s share price dropped by nearly 25%. Saudi National Bank’s announcement only resulted in the market price of the bank’s unsecured bonds; set for a 2027 maturity, dropping to a low of 33% of their par value (These bonds were valued at 90% at the beginning of March 2023). The Swiss government had no other option but to jump into the fray and hastily arrange the Credit Suisse takeover deal with UBS.
The takeover entails “a huge amount of risk”, UBS’ chair Colm Kelleher has warned already, as the concerned shareholders will have their eyes dead fixed on the road ahead, as the survival of both the Swiss and global banking ecosystems will depend on how the deal works in coming months.
The year 2023 has already seen the downfall of the US-based Silicon Valley Bank and Signature Bank, thus giving us the uncomfortable flashback of the 2007-08 financial crises, an event marked by the bankruptcy of Lehman Brothers.
As banks across the world are on the customer reassuring drive, the bond category called additional tier one (AT1) has come under focus now as the UBS’ takeover has wiped out some USD 17 billion worth of bonds of Credit Suisse. The bond owners now stare at the scenario of not receiving a single penny in the payout.
“The extraordinary government support will trigger a complete write-down of the nominal value of all AT1 shares of Credit Suisse in the amount of around 16 billion Swiss francs,” the Swiss Financial Market Supervisory Authority said in its statement, a statement which has now spooked investors about the future of their AT1 holdings in other banks.
Knowing AT1 bonds in detail
AT1 bonds are unsecured, perpetual bonds that banks issue to improve their core capital base. The money raised through these bonds is also used as a shock absorber option by the bank, during crisis moments. If these banks sense trouble, they can convert AT1 bonds to equity or write them down.
AT1 bonds came into being in the wake of the 2008 financial crisis. To cut the long story short, using money raised through these bonds reduces the chances of a taxpayer payout. These bonds are also called Contingent Convertible Bonds (hybrid instruments that are automatically transformed into equity/are written off in the event of a capital shortfall) or CoCos. These long-term bonds also do not carry any maturity date, apart from offering a higher yield.
“After the bank failures that took place in the 2008 financial crisis, many aspects of bank supervision were strengthened, reflecting the critical role that banks have and with the aim of reducing the role of governments in saving them using taxpayers’ money should they run into trouble,” said a March 31, 2023 report from the World Economic Forum.
“One aspect of this was regulators forcing banks to hold more capital to support lending, and being able to draw on this in times of difficulty – for example when loans can’t be repaid or when accessing liquidity becomes tricky,” it stated further.
“This total level of capital that banks are now required to hold is made up of lots of different assets, including Additional Tier 1 bonds, or AT1s. They are part of a broader family of assets known as contingent convertible bonds, or CoCos,” the report observed.
Banks generally hold different levels of capital split into several tiers. At the very top, comes common equity tier 1 capital, which serves as the primary source of bank funding, drawn from shareholders’ equity and retained earnings. Next comes AT1, followed by tier 2 capital, which includes subordinated debt, or the bonds that rank behind senior debt and ordinary depositors.
AT1 Bonds & Credit Suisse
Credit Suisse also had AT1 bonds under its name. In the event of a bank failure, the bondholders get top priority rank than the shareholders, when it comes to receiving their money back. However, in Credit Suisse’s case, the shareholders will receive compensation over the bondholders, something which has spread panic among the bond investors’ community.
A CNN report also states that the main reason behind the phenomenon lies in the fact of Credit Suisse did not apply for bankruptcy and was taken over by other banks. The Credit Suisse shareholders are set to be compensated in the emergency takeover with UBS shares worth the equivalent of Swiss Franc 0.76 a share.
The banking regulators in the European Union (EU) and the Bank of England had to reassure AT1 investors, saying that in the case of another round of bank crises in future, they would be given priority over shareholders.
“Common equity instruments (stocks) are the first ones to absorb losses, and only after their full use would additional tier one be required to be written down…This approach has been consistently applied in past cases,” the EU regulators said.
Big money managers such as Pacific Investment Management and Invesco were among the largest holders of Credit Suisse bonds, owning around $807 million and $370 million, respectively, as per Bloomberg reports. BlackRock had about $113 million at the end of February 2023, although the firm has reduced some of its holdings in the troubled Swiss banking giant now. Funds managed by Lazard Freres Gestion and GAM Investments were also exposed in this whole episode.
The Middle East too had formed deep financial ties with Credit Suisse. In 2013, Qatar converted over $4.5 billion of a special type of debt into AT1 bonds, although it is still unknown whether the Gulf country owned any of them, as the crisis got complicated further. Also, senior Credit Suisse executives were paid in part in AT1notes, as per media reports.
“There will need to be further premium for those securities, at least in the current environment,” said Jerry del Missier, a former chief operating officer of Barclays who is now chief investment officer at Copper Street Capital, while speaking with the Guardian.
“The message has clearly been sent that if a bank appears to be in trouble – and the definition of trouble now includes ‘loss of confidence’ in addition to solvency and liquidity considerations – AT1 holders will immediately price in a high probability of resolution,” the official said further.
Revisiting Yes Bank’s AT1 mess
In 2020, India-based Yes Bank got into a tangle, as the Reserve Bank of India-appointed administrator wrote them off, resulting in angry bondholders knocking on the court’s door. While the Bombay High Court set aside the write-off decision taken by India’s apex banking body, the matter is now expected to go to the country’s Supreme Court.
In 2016 and 2017, Yes Bank issued AT1 bonds to increase its capital base, thus providing higher yields than other comparable bonds. However, by March 2020, the tales of Yes Bank’s financial trouble became the market buzz, as the financial institution’s loans became Non-Performing Assets (NPAs).
By 2019, credit rating agencies had downgraded the bank, which resulted in the market value erosion for Yes Bank. The RBI action came only on March 2020.
The RBI-appointed administrator put in place a scheme for its revival, under which the State Bank of India, along with some other financial institutions, were tasked to purchase Yes Bank’s equity. AT1 bondholders were overlooked by this revival plan.
Yes Bank employees allegedly overemphasised the returns of these risky bonds, apart from downplaying the market dangers of investing in these bonds. Securities and Exchange Board of India not only penalised the bank’s top management, but restricted retail investors from investing in the AT1 bonds.
Future tense for AT1 bonds
In the lead-up to the Credit Suisse crisis, the size of the AT1 market was around $260 billion, as per a Financial Times report. However, in the last few weeks, things have changed.
In March 2023, the Swiss bank’s takeover by UBS resulted in a massive sell-off of the risky bank debt, as the merger deal resulted in the wipe-out of $17 billion worth of Credit Suisse bonds. Swiss banking regulators added more to the investors’ miseries by writing the value of these bonds down to zero.
However, the AT1 bonds made a market recovery in April’s first week as a Bloomberg index of contingent convertible bonds globally went up by 10% to a similar level seen before UBS’ Credit Suisse takeover. Financial Times also reported about the iBoxx index of AT1 prices recovering significantly.
“Investors say they have been reassured by statements from regulators elsewhere that the Swiss decision to leave AT1 holders with nothing would not set a precedent for the wider $260 billion market,” commented the report.
Still, AT1 prices are expected to remain well below levels seen at the start of 2023, amid wider investor concerns over the global banking sector’s health. The news of Mitsubishi UFJ Financial Group delaying the issuance of new debt also shows the nervousness from the financial institutions.
A report by Value Research predicts that the AT1 bonds will likely face significant changes from April 2023, as they will be exposed to interest rate risks amid the monetary policy tightening from central banks all around the globe, thus becoming extremely volatile.
“That’s because there’s an inverse relationship between bond yield and price. If the bond price falls, its yield goes up. In that case, the NAV of your debt fund will fall too because it derives its value from the price of the bonds it holds. Also bear in mind that the higher the bond maturity, the higher the impact. Given that AT1 will be treated as 100-year instruments, any fall in bond price would be damaging for them,” the study commented further.
Despite the AT1 bonds making a market rebound, they are not completely out of the woods yet. And the ongoing global banking crisis is not over yet. We are still waking up to the news of central banks going for interest rate hikes. AT1 bonds will definitely be exposed to these interest rate risks and after the Credit Suisse saga, things have complicated further for the investors.