Dissecting the Fight Over Credit Suisse Bonds’ Ashes

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

Two months on from Credit Suisse’s de-facto failure—and Swiss authorities’ decision to wipe out certain subordinated bondholders while letting shareholders walk away with a few bucks—said subordinated bonds continue hogging attention. These securities, a form of Alternative Tier One (AT1) capital known as contingent-convertible (co-co) bonds, are designed to convert to equity (and potentially get written down to zero) if a bank gets in trouble and needs to build capital in a pinch. Outside Switzerland, bank resolution regulations stipulate that co-co bonds don’t get “bailed in” until shareholders have been wiped, so when that didn’t happen in the case of Credit Suisse, it raised all sorts of eyebrows—and concerns about future AT1 issuance. Many worried the disparate treatment and confusion it sowed would rob banks of a key—make that required—funding source. Others saw it as a call for revised regulation, a key risk right now, in our view. Yet some recent developments have helped the fog start to lift, and as uncertainty falls, sentiment toward Financials overall should continue improving.

As we detailed at the time, once the dust settled from Credit Suisse’s implosion and shotgun wedding to rival UBS, the co-co market looked likely to return to normal. At the time, co-co yields had spiked (and prices dropped) as markets dealt with the fear that they would be behind shareholders in the pecking order during future bank failures—a fear that seemed divorced from reality. Swiss rules are unique in imposing losses on co-cos before shareholders in certain circumstances, and that possibility was enumerated in the bonds’ prospectus. EU rules are different and enshrined in the bloc’s “bail-in” procedures, and the ECB quickly confirmed the events in Switzerland wouldn’t change things for EU banks. Regulators elsewhere, like in Hong Kong and Singapore, quickly followed suit, and co-co interest rates eased back and prices recovered (though not all the way to pre-Credit Suisse levels).

Now the market for new AT1s is picking up, too, shattering fears that banks would lose this key funding source. Last month, one of Japan’s largest banks sold $1 billion worth of AT1 bonds, breaking the ice after Credit Suisse. Demand was solid, and investors didn’t demand a huge premium—spreads on the new bond were just a smidge wider than a comparable offering in December. With that vote of confidence in, more sales are in the offing. Australia’s largest bank announced a roughly $500 million AT1 sale Tuesday, which it expects to finalize next week. Another large Japanese bank is also planning an offering for late next week. The more investors see this market functioning just fine, the more confidence should improve.

Counterintuitively, this week’s decision on whether Credit Suisse’s AT1 wipeout constituted a “credit event” that should trigger credit default swap (CDS) payouts should also help shore up confidence. Some hedge funds owning Credit Suisse’s CDS petitioned for this, arguing that when the bank wrote its co-cos down to zero as part of its merger with UBS, it constituted a default. This line of logic seems a stretch, however, considering the CDS in question applied to other forms of subordinated debt—not the AT1 securities. So if the Credit Derivatives Determination Committee (CDDC) had ruled in favor of the bondholders, it would have set a rather strange precedent that risked upending Switzerland’s bail-in pecking order again. But the CDDC rejected the petition, confirming the AT1 wipeout wasn’t a credit event and that they are a sub-subordinate security. To us, that seems right. The possibility of bail-in and writedown is part of the bond’s design and a big part of the extra risk that enables their higher coupon payments. If a potential writeoff is part of the bond’s purpose and written into the prospectus, we have a hard time seeing how an actual writeoff would therefore violate the terms and constitute a broader default. It seems a bit odd this actually made news, but we guess people just needed reminding that AT1 debt is vastly subordinate and different from the rest of the bonds in banks’ capital structure?

Then again, another piece of AT1 news this week suggests that reminder is actually pretty necessary. Apparently, some stakeholders are lobbying the European Banking Authority (EBA) to tweak AT1 rules in order to boost investor interest. According to a Bloomberg report, suggestions included forcing banks to cease paying dividends in tough times before they skip an AT1 interest payment and mandating that all skipped payments are delayed, not canceled outright. But here too, as with the CDS petition, all of this seems to be contrary to the point of AT1s—and the return of the AT1 market suggests changes increasingly amount to solutions seeking a problem. Mercifully, the EBA agrees, noting it doesn’t see the changes as necessary, especially since they would require wholesale changes to EU bank bail-in rules. That would be a very big can of worms, and reopening it would probably introduce more uncertainty. As ever, regulatory change can hurt as much as it helps—inaction here is a plus, in our view.

So overall, outside Switzerland, the dust is settling and markets are gaining some clarity—both on regulations and investors’ interest. Within Switzerland, it is still a bit of a minefield, due largely to Credit Suisse bondholders’ lawsuit against Swiss financial regulator Finma, which argues its order to write down the AT1s was unconstitutional. The case is ongoing, but last week the judge ordered Finma to disclose its decree mandating the writedown, which had been sealed until now. According to Financial Times, which obtained a copy, the Swiss government also expanded Finma’s powers in the days before the writedown, expressly giving it the power order AT1 writedowns. As for the decree, Financial Times notes it rationalized the writedown by claiming Credit Suisse’s use of government-backed liquidity facilities constituted a “viability event,” which could set a weird precedent by exposing every Swiss bank that borrows from the central bank to the risk of writedowns. We don’t think this means much for the EU or banks globally—again, Swiss regulations have unique quirks that don’t apply elsewhere—but it bears watching, and we reckon the ruling, whichever way it goes, will add some much-needed clarity.