Evening Brief – 03.20.23

Much to the shock of Europe’s $275 billion Additional Tier 1 (AT1) Capital market, nearly $17 billion in Credit Suisse AT1 bonds, also known as Contingent Convertible (CoCo), bonds were written down to zero even as equity holders received over $3 billion. That’s not how it’s supposed to work.

AT1 investors were blindsided with news they’re not getting any compensation as the long-established hierarchy of paying bondholders first over equity holders in debt recovery had been flipped.

AT1 bonds contribute to the total level of capital banks are required to hold. Given they are at the riskier end of the fixed income spectrum and their subordinated position within the capital structure, these bonds offer a higher yield than more senior debt.

These instruments were created after the global financial crisis to serve as shock absorbers when banks start to fail. They are designed to impose permanent losses on bondholders or be converted into equity if a bank’s capital ratios fall below a predetermined level, effectively propping up its balance sheet and allowing it to stay in business.

This decision to wipe out AT1 bond holders creates several issues. Firstly, as equity value remains in Credit Suisse, holders of AT1 paper may strike a legal challenge, having the value of their AT1 shares written down.

Secondly, AT1 investors need to consider what happens if this scenario is repeated – given the risk of contagion in the banking system is possible. If AT1 debt can be written off but common equity is made good, the value of AT1 debt could be severely affected – possibly freezing up the entire market.

This could be a major problem for other financial institutions. AT1 securities are banks’ tier 1 capital as the name implies and used to assess the bank’s capital ratio. A repricing could have a serious effect on bank stability.