• AT1 bonds are back in demand after a string of bad news from the banking sector 
  • The failure of Credit Suisse in March took markets by surprise but it was not unforeseeable 
  • The asset class consistently offers higher yields that compensate for high idiosyncratic risks
  • Volatility is driven by a complex market pricing mechanism rather than weak bank fundamentals

On a late Monday evening in August, the Italian right-wing government unexpectedly announced a new 40% tax on banks’ ‘windfall’ profits derived by the higher lending rates. Shares in Italian banks tumbled, banking executives cried foul, and analysts poured scorn over the measure. The government, which was hoping to raise up to €3bn to help families and small businesses, backtracked shortly after, scaling back the tax.  

This is just the latest example of the inextricable relationship between banking and politics. Investors in AT1 bonds issued by Credit Suisse learned the lesson at a great cost, when in March this year Swiss regulators allowed the bank to write down the bonds to zero. 

The bank’s share price had been falling for months, until the largest shareholder, Saudi National Bank, said in March that it would not build its stake above 10%, for regulatory reasons. The bank’s shares fell further and the markets started to question its viability. 

Quite apart from the many scandals involving the bank over the years – from its role in the 2013 forex manipulation scandal to its ties with the failed supply-chain finance provider Greensill Capital – Credit Suisse had been suffering due to the poor performance of its investment banking arm. Following rumours about its financial health in late 2022, the bank’s wealth management business suffered large client outflows. In February, the bank had reported a loss for the year of CHF7.3bn (€8.2bn), the largest since the 2008 Global Financial Crisis. 

Eventually, fears over the Credit Suisse’s solvency turned into a full-blown liquidity crisis and a run on the bank. The crisis would have spread further if UBS, the bank’s arch-rival, had not agreed to take over Credit Suisse for CHF3bn. The deal had been mulled over for years but never quite seemed achievable. 

For it to come through, however, the Swiss Federal Council had to pass an emergency law to provide the legal basis for the write-down of nearly €16bn of AT1 bonds issued by Credit Suisse. This allowed the Swiss National Bank to guarantee liquidity assistance and maintain financial stability.

High risk-reward profile 

The financial world then seemed to part into two factions. One was outraged that politics could interfere to such an extent and force AT1 investors to suffer a loss of such magnitude, particularly while investors in the bank’s equities had not received the same treatment. The other faction found no fault in the behaviour of policymakers.  

Charles-Henry Monchau, CIO at Banque Syz

“The news that the bonds were being written down to zero came as a shock”

Charles-Henry Monchau

Charles-Henry Monchau, CIO at Banque Syz, says: “The news that the bonds were being written down to zero came as a shock because the liquidity and capital ratios of Credit Suisse were above minimum requirements, and the shares were not wiped out to zero. The markets simply did not understand it.

“But the issues with the investment banking side and the crisis of confidence in the bank were simply too great.”

Several Swiss pension funds surveyed by IPE at the time of the deal had relationships with Credit Suisse, either as shareholders or clients, but none had significant holdings in the bank’s securities or were greatly affected by the change in ownership. Meanwhile, plenty of portfolio managers in AT1 bonds have been quoted by financial media expressing dismay at the treatment they endured.

However, even experienced investors in the asset class endorse the fairness of the process, pointing to the nature of AT1 bonds. 

The asset class was effectively created in the aftermath of the global financial crisis as the Basel III regulatory framework sought to increase the systemic resilience of the banking sector. 

AT1 bonds, short for additional tier-1 bonds, were issued by banks to strengthen their capital ratios, in compliance with national and supra-national regulation. They started trading around 2013, issued by the largest banks first. New issues by smaller banks are relatively rare and most of the activity on this market relates to refinancings. The size of this market, which has now reached maturity, is somewhere between $250bn and $300bn. Taking into account issues in US dollar, sterling and euro, there are about 70 different issuers. 

A variant of AT1 bonds is ‘contingent convertibles’, or cocos, which can be converted into equity in some cases. 

However, the main risk of investing in AT1 bonds is to lose everything, according to Jérémie Boudinet, head of investment grade credit at La Française Asset Management. This is because one of the main features of AT1 bonds is a ‘loss absorption mechanism’, whereby they can be written down to zero, or converted into equity, once the issuers’ common equity tier 1 (CET 1) capital ratio – a key measure of a bank’s capitalisation – falls below a certain threshold. 

In that sense, no injustice was done to investors in Credit Suisse AT1 bonds. Boudinet says: “I saw some comments from market participants that were honest, others not so honest. In theory, if regulators want to impose losses on coco holders the value of the equity also must be brought to zero. But the fact is that bank resolutions are political decisions, first and foremost, driven by the need to maintain financial stability.”

Credit Suisse was not the first issuer of AT1 bonds to fail. In 2017, Spain’s Banco Popular suffered a bank run and the Single Resolution Board (SRB), the European Union’s central banking resolution authority as part of the Banking Union, intervened by allowing the bonds to be written down to zero. Santander, Spain’s largest bank, subsequently acquired Banco Popular for the symbolic sum of €1. 

The disgruntled investors in Credit Suisse bonds might point to the Banco Popular precedent to argue their case that the losses imposed on bond and equity investors should have been proportionate. However, as Boudinet says, because bank resolutions are political matters, “you cannot always assume a clear blueprint”.

There are two other main risks embedded in AT1 bonds, in Boudinet’s view. There is the risk of the coupon not being paid, which because of the nature of the instrument does not trigger a credit event, and has never happened in the European market. Then there is risk that the bond is not redeemed at its first call date, also known as extension risk.

“This is where the asset class gets interesting,” says Boudinet. 

“As AT1 bond geeks, we ponder whether the market is pricing the possible call on the bond.  We ask what the next coupon will be, if the bond is not called, and when the frequency of future calls will be.

The potentially different outcomes have a significant effect on market pricing. When spreads and prices are volatile, as has been the case after the Credit Suisse failure, is not necessarily because investors see bank fundamentals as weak. It is, to a large extent, a function of how investors price call probabilities.”

One exception, perhaps, was the volatility in the AT1 bonds issued by Deutsche Bank in the aftermath of the Credit Suisse deal. Boudinet boils that down to panic. He says: “There was some contagion, and we saw spreads widening. There was a lot of panic around Deutsche Bank, which was almost ironic, given that no one really thought anything serios could happen to the bank, because the fundamentals had improved materially from a few years ago. But the volatility disappeared within a week.”

Issuers return to the market 

The good news for existing and prospective investors in AT1 bonds is that the market resumed functioning shortly after the Credit Suisse debacle. 

“The market has recovered well, and we were almost surprised at the speed at which it did recover,” says Banque Syz’s Monchau. “At one point, investors did not know whether there would be a market for cocos the next day, and whether the volatility would spill over to the wider credit markets. But investors recognised that most of the issuers on this market are well capitalised.”

The average yield to call, which is the conservative way of pricing AT1 bonds, is in the high single digits and the yield to perpetuity is above 10%. There are few new issues, as the large banks have filled their capital buckets, but smaller banks can access the markets when positive sentiment prevails. This year, a small Greek bank, called Alpha Bank, issued an AT1 bonds with a coupon over 11%. 

Larger banks are also coming to the market, however. In Japan, at the end of May, the Mitsubishi UFJ Financial Group raised ¥570bn (€3.6bn), for a non-callable 10-year AT1 bond with a coupon of 2.127%. In June, Spanish banking group BBVA placed an AT1 bond callable in December 2028 redemption with an 8.375% coupon, raising €3.1bn. Bank of Cyprus also raised €220m for an AT1 bond callable in December 2028, with a 11.875% coupon. 

“It feels like investors are going back to basics and putting more emphasis into analysing the fundamentals of banks, including their solvency and liquidity metrics. For a while, it seemed as though investors assumed that banks were too big to fail,” says Boudinet. 

In Monchau’s view, however, analysis of a bank’s fundamentals can only get investors so far. 

“The fact is banks are black boxes. This is why investors should favour larger banks, where issues in one division can potentially be offset by other parts of the business,” he says.

“Most importantly, when assessing banks, investors should focus on management and only invest in top teams.”

But that is precisely why the asset class offers comparatively higher yields, points out Boudinet. 

“Banks tend to fail due to issues with liquidity, rather than with solvency. And when serious problems such as those experienced by Credit Suisse arise, investors face a binary outcome. Either they win big or lose big, which is why the compensation is so large,” says Boudinet.