The mini-crisis in global banking reached another head over the weekend with the rushed takeover of Credit Suisse by fellow Swiss banking giant UBS. But while the knock-down price of $3.25bn represents a significant haircut for Credit Suisse’s shareholders (the bank had a market cap of around $8bn only last week), the real scalping has been endured by holders of its additional tier 1 (AT1) debt, also known as contingent convertibles or CoCos.
AT1 debt was introduced as part of the more stringent capital requirements placed on banks following the global financial crisis, and should rank ahead of equity in the capital structure in the event of a bank failure. However, Credit Suisse did not technically fail, and a quirk in the Swiss system allowed the regulator to overturn the capital hierarchy in order to wave through the deal.
Rob James, who manages bond funds at Premier Miton, including the Premier Miton Financials Capital Securities Fund, explains: “Within the Swiss banking laws, AT1 can be written down without equity being involved under very specific conditions. Extraordinary Government Support is the required condition, and it seems that a new law was passed over the weekend classifying the liquidity assistance and guarantee as Extraordinary Government Support, thus allowing FINMA, the regulator, to enact the write-down. In a normal resolution in Switzerland, the capital hierarchy is preserved.”
While in Switzerland, the AT1 terms are contractual, James explains that elsewhere in Europe – including the UK – the terms are written into statute, under the Banking Resolution and Recovery Directive (BRRD). “Under BRRD the point of non-viability requires that all creditors are treated at least as well as they would have been in a standard liquidation, with AT1 ranking ahead of equity in this case,” he says.
For bond fund managers, AT1 bank debt (and restricted T1, or RT1 debt – the insurance company equivalent) has been an attractive source of enhanced income in a decade when interest rates and coupons on traditional bonds have been ultra-low. In addition to the protections offered by its place in the capital structure, the fact that most banks (even Credit Suisse, James argues) have been and remain well capitalised should mean the debt is a relatively safe bet.
Yet while the treatment of Credit Suisse’s AT1 holders has sent shockwaves through bond markets, and drawn the censure of both the Bank of England and the European Central Bank, James says reports of the AT1 sector’s ‘death’ have been exaggerated (with apologies to Mark Twain). “As the dust has settled and the overall perception appears to be that this type of solution only applies to Switzerland, the situation has improved,” he comments.
Peter Doherty, head of fixed income at Sanlam Investments UK, and manager of the Sanlam Hybrid Capital Bond Fund, goes further. “I think the Credit Suisse rescue has shown the lessons learned from the global financial crisis – it was put to bed and stabilised over a weekend – and given the specific language around Swiss AT1 securities allowing them to be written down, it is not harsh; it is simply a loss-absorbing security absorbing some loss,” he says.
For both Doherty and James, the fundamental issue with Credit Suisse was one of liquidity rather than solvency; Doherty says this is also the case with the recent spate of US regional bank blowouts. “The price of liquidity is underestimated,” he argues, adding that he believes both the HSBC bailout of Silicon Valley Bank and UBS’s takeover of Credit Suisse will prove to be highly lucrative for the acquirers in the long term.
Both the Sanlam and Premier Miton funds have a focus on subordinated debt, although James’s fund has higher exposure to AT1s (using the ICE BofA Contingent Capital GBP Hedged index as a benchmark), while Doherty holds a broader range of securities, favouring insurance issuers as well as bank bonds higher in the capital stack.
“Although from a systemic risk point of view I don’t think there is a problem with AT1 debt, insurers are lower-volatility than banks; [because they are not at risk of a sudden run on deposits] they go broke over a long period, and there is plenty of time to make decisions,” he says, pointing out that L&G’s RT1 debt is now yielding in the high single to low double digits, which is highly attractive from a stable, globally diversified business.
“The flipside of a mini-crisis is an opportunity, and if you stay with the highest-quality issuers, even buying the most risky notes still isn’t that risky,” Doherty adds. James concurs: “Given the fundamental health of the system, as well as the names we own in the portfolio, we see this is as buying opportunity in the asset class as a whole. We see the likelihood of multiple write-downs as highly unlikely and think that this presents an opportunity for investors at current pricing.”
While current yields on subordinated debt have risen in response to recent market events – in some cases to inflation-beating levels even from high-quality issuers – Doherty believes the new issue market could be quiet for a while. “Although the market has probably retraced 60-70% of Monday’s downdraft, there will be a premium to pay for new issuance, and issuers with current bonds who would otherwise have called and replaced them will probably leave them to the next call date,” he says. “It will be interesting to see the dynamics of the market, as issues have to get done. I can see the next issuer being an insurance company; it will take someone with some bravery and a strong name, but there is still appetite for these securities.”
Morningstar data shows 51 UK-domiciled funds had exposure to Credit Suisse AT1 debt at the latest available date, but with an average portfolio weighting of just 0.5%, the debacle is unlikely to have a significant effect on bond fund holders. Therefore, with double-digit yields available on some bonds and with the reassurance that the Credit Suisse situation would not be repeated outside of Switzerland, the opportunities in subordinated debt arguably outweigh the threats, as long as investors continue to focus on issuer quality, stability and liquidity.
