The Swiss authorities decided to use their power to write down Credit Suisse (CS) Additional Tier 1 (AT1) bonds (also known as contingent capital or CoCo bonds) in full, even though equity was not written down to zero as part of the deal where UBS acquired CS for CHF 3bn. While a resolution of CS was avoided, the Swiss government provided CHF 9bn second-loss guarantee to UBS (approved with a new law ) and therefore was allowed to write-down the AT1s. This is clearly an unfortunate event for CS AT1 investors.
CS started from a weak position. After a long period of poor performance, deposit outflows accelerated after the news of a lack of additional support from Saudi National Bank, the largest CS shareholder. Ironically, this was probably more driven by the size of their existing holding rather than a negative view of the bank.
The most surprising outcome was that the regulator allowed a full write down of CS AT1s while leaving residual value to equity holders. In order to persuade UBS to make the transaction the regulator not only guaranteed potential losses (CHF 9bn) on the valuation of the assets, but also permitted the AT1s write down. This appears to be legitimate: CS’s AT1 documents allow this action to be taken if the bank’s capital ratios fall below a certain point, which is common for AT1s across the globe. However, they also provide for a write-down if a point of non-viability is reached along with the need of “extraordinary support from the public sector”. CS found themselves in the second case.
So AT1 investors knew the risk: what’s shocked many market participants is that equity holders were paid CHF 0.76 a share in UBS shares despite having an explicitly weaker position in the capital structure. Does this set a precedent for AT1s? In our view it does not. While Swiss regulators have pursued an unusual course of action, other regulators were quick to distance themselves.
The European Central Bank (ECB) clarified immediately that common equity would be the first to absorb losses:
“Common equity instruments 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 and will continue to guide the actions of the SRB (Single Resolution Board) and ECB banking supervision in crisis interventions.“
The Bank of England (BoE) also confirmed that “AT1 instruments rank ahead of CET1 and behind T2 in the hierarchy.”
This is therefore an idiosyncratic event, in our view. CS was in a very weak position and at risk from deposit flight in an environment of rapidly tightening liquidity. Given public liquidity was used, their AT1s were wiped out. It’s rather unusual that equity holders received some small compensation, but it’s clear to us that this is not a course other regulators would follow.
At the same time, we had high conviction that CS is a systemically important bank which the Swiss authorities would stand behind, and so it has proved. We therefore owned CS senior debt, which has been protected throughout this process, and has delivered positive performance in particular after the news of the UBS takeover.
Looking at the rest of our exposure, over the past few months we identified that tighter liquidity and higher recession risk would put pressure on bank valuations. Against that challenging backdrop, we have had other bank CoCos exposure at the minimum permitted by our prospectus (a little over 75%), preferring higher seniorities and cash. This positioning has helped the strategy materially outperform its benchmark.
We would expect the AT1 market to stabilise over time as perspective returns to the market. The asset side of CS was not fundamentally impaired. What we saw last week was a loss of confidence for a bank that was already in a challenging restructuring path, leading to deposit withdrawals which were exacerbated by miscommunication from a key shareholder.
Other European banks are in a much more robust situation, with better profitability profiles and lower levels of uninsured deposits.
As well as a higher yield, the multiple layers within banking capital structures allow active managers like us the ability to implement our fundamental analysis of banks. We can take AT1 risk in healthy banks and take no risk or only senior risk in weaker institutions.
Even after the CS debacle, the European banking system looks very healthy, in our view. Capitalisation ratios are 2-3x higher than in 2007. The banks are stress-tested regularly on a capital and liquidity perspective. Given that reality, the yields available on AT1s relative to the risk involved are extremely attractive — even more so after recent events. As always in fixed income, you need to avoid the bad apples through rigorous selection as the case of CS clearly demonstrates.
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