The wipeout of $17bn (£14bn) in Credit Suisse (CH:CSGN) additional tier 1 (AT1) debt as part of its takeover by UBS (CH:UBSG) has been met with much angst, but there is limited evidence that aggrieved bond investors will force up banks’ cost of capital to unprecedented levels.
AT1 bonds, typically classed as contingent convertibles, or cocos, are designed to be wiped out or convert to equity at times of financial stress. UK banks were early adopters following the financial crisis, and, as of 2018, more than a third of outstanding European coco debt belonged to UK issuers.
While AT1s are one of the riskiest forms of debt – as shown by the elevated coupons that they offer – as bonds, they traditionally rank higher in the capital hierarchy than equity. The Credit Suisse deal upended that order once again, prompting dismay and a back-and-forth on social media over the precise wording of the bonds’ prospectuses.
The mooted possibility of legal action by debtholders brings to mind similar court dates following the writing down of AT1 debt at both Spain’s Banco Popular in 2017 and India’s Yes Bank in 2020.
Yet all three cases are distinct, and both the European Central Bank and Bank of England sought to clarify this week that they would seek to respect the conventional hierarchy of claims in the event of a failure in their jurisdictions.
While bond conversion triggers are at regulators’ discretion in each case, there are clear differences between Swiss cocos and their European equivalents. The Swiss versions, such as those issued by Credit Suisse, are known as the 'permanent writedown' variety; others only allow for temporary writedowns and the bulk of UK cocos – 42 out of 46 issues as of a 2021 sample by Bank of England researchers – are based on the “conversion to equity” principle.
The more pertinent issue for those holding financials is whether investors trust in this distinction. If not, the events of this week could permanently increase the cost of capital for banks. If AT1 markets were to wither away, banks would have to increase common equity tier 1 (CET1) capital ratios in recompense, potentially hurting capital returns.
AT1s account for around 3 percentage points of risk-weighted assets at Barclays (BARC) on top of its 14 per cent CET ratio, according to Société Générale estimates. At NatWest (NWG), the equivalent figures are 2 and 14 per cent.
Barclays Research, in an admirable show of analyst independence, agrees that Barclays would be the most exposed were AT1 issuance costs to rise materially: it estimates a 100 basis point increase would equate to 1.7 per cent of the bank’s estimated pre-tax profit for 2023.
But fund managers expect the yield uptick to be shortlived: one head of fixed income at an asset manager who did not wish to be named said the “premium should normalise as investors realise the Swiss are an exception”. TwentyFour Asset Management’s Dillon Lancaster said the fund firm had been “very reassured” by the European and UK regulators’ statements.
The relative lack of impact on performance over the past week supports the view that AT1 bonds will remain a viable source of funding for institutions in the medium term.
The Invesco AT1 Capital Bond UCITS ETF (AT1) fell 6 per cent on Monday morning but had recovered the bulk of those losses by the middle of the week. But it remains 13 per cent down since the start of March, illustrating a wider point: bank funding, of all stripes, is more expensive than it has been. The AT1 storm may blow over, but the overall cost of capital for financials is still elevated. Financing needs are minimal for now: banks will hope fears have subsided by the time they return to market.
