The value of a class of convertible bonds issued by banks plunged in value on Monday after Credit Suisse’s securities were completely written down to zero by the Swiss regulator.
The Swiss Financial Market Supervisory Authority announced that all of the bank’s 16 billion francs ($17.2 billion) of additional tier 1 bonds – also known as AT1 bonds, contingent convertible bonds, or CoCos – will be written down to zero as part of its merger with UBS UBS, +4.95%.
The write down has worried investors of the $275 billion AT1 bond market.
The Invesco AT1 Capital Bond UCITS exchange-traded fund AT1, -5.72% sank more than 16% on Monday. Deutsche Bank’s DB, +1.26% £650 million 7.125% note fell to 66 cents – its largest ever one-day drop, according to Bloomberg.
“The UBS-CS deal might have avoided an immediate risk event, but the AT1 write down has added an uncertainty which could persist for weeks if not months,” said Mohit Kumar, chief financial economist in Europe at Jefferies.
“Given the large amount of AT1s outstanding, this would also raise the prospect of losses for other investors and the ability of banks to use them as a funding source in the future,” he added.
So how do AT1 bonds work?
Normally these risky bonds are converted to equity when a bank’s total capital falls below a trigger level.
Usually they are written down after all the equity capital is erased, but that did not happen this case. Credit Suisse equity holders will receive 1 UBS share for every 22.48 Credit Suisse shares held. Credit Suisse shares fell by over 60% on Monday.
Kumar questioned the “legality” of the move as equity investors didn’t lose everything in the deal. Credit Suisse’s largest shareholder, the Saudi National Bank, has lost more than $1 billion in value.
“The current deal precedence where equity investors have some value preserved while AT1s have been written down raises questions about the legality of the move and the relative valuations of AT1 bonds,” Kumar said.
Credit Suisse’s prospectus, however, did mention the possibility that the securities could be wiped out.
“We think it is the fact that shareholders have essentially been bypassed in the UBS/CS merger and the fact that AT1 has been bailed in is weighing on markets,” said Peter Schaffrik, global macro strategist at RBC Capital Markets.
European financial organizations welcomed the move on Sunday. A statement by The Single Resolution Board, the European Banking Authority and ECB Banking Supervision said that AT1 bonds will remain an important component of the capital structure of European banks.
“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 and ECB banking supervision in crisis interventions,” it said.
Justin D’Ercole, co-founder of ISO-MTS Capital Management LP, a fund focused on bank securities, told MarketWatch that AT1 investing is likely to continue but it will cause “pricing differentials” between banks.
“I think in another month or two, there may be lawsuits over this trying to capture or recover some of the losses from AT1 bondholders,” he added.
And it may be coming sooner than anticipated. Law firm Quinn Emanuel Urquhart & Sullivan said on Monday that it was exploring potential legal actions on behalf of AT1 bondholders.
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