A Round Trip in European Bank Funding Markets

Editors’ Note: MarketMinder does not make individual security recommendations. The below merely represent a broader theme we wish to highlight.

Just over eight months ago, European bank funding markets were allegedly broken beyond repair. Credit Suisse had just failed, imposing full losses on certain subordinated bondholders in the process—an unusual outcome, considering stockholders didn’t walk away empty-handed and bondholders are typically senior to them in a bankruptcy resolution. Even knowing Swiss rules are unique, pundits warned the strange chain of events could cause investors to reassess Additional Tier 1 (AT1) bonds across the UK and Europe, making it difficult for banks to secure necessary funding. And for a while, that looked sort of right, as AT1 returns sank and issuance stalled. Yet now, the market is storming back, showing this, too, was a false fear.

For the full story of what happened back then, you can check out our coverage at the time. But in short, when Credit Suisse failed and regulators orchestrated its sale to fellow Swiss megabank UBS, they “bailed in” its AT1 bonds by writing their value down to zero—imposing full losses on the bondholders. In a vacuum this wouldn’t be strange, since AT1 bonds are designed to absorb trouble and reduce the likelihood of a taxpayer bailout. So it went this time, courtesy of the UBS buyout. But the buyout also offered small compensation to Credit Suisse’s equity shareholders, giving them 1 share of UBS stock for every 22.5 they owned in Credit Suisse.

This differed radically from the typical pecking order for European bank bail-ins. In EU countries and the UK, AT1 bondholders rank higher than shareholders, meaning shareholders would have to take full losses before losses could be imposed on AT1 bondholders. Yet Switzerland isn’t in the EU. It has its own rules, and the Credit Suisse AT1 bonds’ prospectuses outlined the risk of this scenario playing out. In the immediate aftermath, regulators throughout the UK and EU stressed that their own rules and procedures remained intact and Credit Suisse wouldn’t create a new blueprint. They affirmed AT1 bonds would still outrank stock. But this was a panicky time, and panicky markets aren’t always rational, so—using AT1 ETF returns as a proxy—AT1 prices plunged, creating big questions about whether investor demand would return.

Initially, it didn’t. Issuance was nil in April and May, but two European banks broke the ice in June. The issues were small but well oversubscribed—a promising sign that investors’ appetites were returning.^[i] A few more offerings followed in August and September, also attracting decent demand. And now, after a brief pause in October, the floodgates have opened! As Bloomberg reported this week, European AT1 issuance in November is the highest since 2015, and demand is swamping supply.^[ii] Even UBS issued some this month.^[iii] The AT1 ETF we tracked is now just about flat on the year on a total return basis, recovering its springtime decline. Bank funding markets, it seems, are back to normal.

We aren’t saying we told you so or anything, but this is a really important thing to keep in mind—it shows the peril in extrapolating panicky conditions forward indefinitely. Markets can and do seize up temporarily, especially in less-liquid arenas. But it is often based more on sentiment rather than some fundamental change, and sentiment has a way of evening out over time. Simply remembering this can help you avoid making a hasty decision in the heat of the moment.

Second, it is a good reminder of the real risk investors confronted: the risk of regulators capriciously picking winners and losers. It wasn’t that investors thought AT1 bonds were risk-free and then got a rude awakening in March, forcing them to reassess owning an entire class of bonds. It was more, the rules say this thing, but then this other thing happened, and is there a chance governments won’t follow the rules moving forward and I could take a loss that I don’t expect based on the current playbook? This hasn’t been tested since Credit Suisse failed, as no UK or EU bank has gone under. But it seems time and consistent messaging from central bankers and other key players have shored up confidence, enabling investors to plow back in with gusto.

Meanwhile, markets pre-priced all of it, as they usually do, with MSCI World Index Banks rebounding noticeably before company filings and AT1 sales confirmed the industry’s health. They have endured plenty of volatility alongside broader markets since then, but even so, they are up from March’s lows. Waiting for an all-clear, which still hasn’t really come, would have been costly. So the return of AT1 bonds isn’t some massively bullish driver from here—but it is a nice confirmation that things weren’t so bad as feared.