What are AT1 bonds and why are Credit Suisse’s now worthless?

Investors in a riskier type of Credit Suisse’s bonds had the value of their holdings slashed to zero Sunday after Swiss authorities brokered an emergency takeover of the bank by rival UBS.

On Sunday, the Swiss National Bank (SNB) announced that UBS would buy Credit Suisse for 3 billion Swiss francs ($3.25 billion) — or about 60% less than the bank was worth when markets closed on Friday. Credit Suisse shareholders will be largely wiped out, receiving the equivalent of just 0.76 Swiss francs in UBS shares for stock that was worth 1.86 Swiss francs on Friday.

But it is the owners of Credit Suisse’s $17 billion worth of “additional tier one” (AT1) bonds who have been left fully in the cold. Swiss authorities said those bondholders would receive absolutely nothing. The move is at odds with the usual hierarchy of losses when a bank fails, with shareholders typically the last in line for any kind of payout.

“The extraordinary government support will trigger a complete write-down of the nominal value of all AT1 shares of Credit Suisse in the amount of around 16 billion [Swiss francs],” the Swiss Financial Market Supervisory Authority said in a statement Sunday.

David Benamou, chief investment officer at Axiom Alternative Investments, a French wealth management firm with exposure to AT1 bonds, called the decision “quite surprising, not to say … shocking.”

The European market for such bonds is worth about $250 billion, according to the Financial Times. It could now go into a deep freeze.

What are AT1 bonds?

AT1 bonds are also known as “contingent convertibles,” or “CoCos”. They were created in the wake of the 2008 financial crisis as a way for failing banks to absorb losses, making a taxpayer-funded bailout less likely.

They are a risky bet — if a lender gets into trouble, this class of bonds can be quickly converted into equity, or written down completely.

Because they are higher-risk, AT1s offer a higher yield than most other bonds issued by borrowers with similar credit ratings, making them popular with institutional investors.

What’s the controversy?

It is not the write-down of Credit Suisse’s AT1 bonds that has rocked investors, but the fact that the bank’s shareholders will receive some compensation when bondholders will not.

Ordinarily, bondholders are higher up the pecking order than shareholders when a banks fails. But because Credit Suisse’s demise has not followed a traditional bankruptcy, analysts told CNN, the same rules don’t apply.

“The hierarchy of claims remains applicable in the EU… there is no way that shareholders can be paid and AT1 holders [are] paid zero,” Benamou said. “The decision taken by the Swiss authorities is really very strange.”

Michael Hewson, chief market analyst at CMC Markets, told CNN: “It appears that in this case, because it was not a bankruptcy situation it was considered that AT1 bondholders and shareholders would both feel the pain.”

EU banking regulators and the Bank of England moved Monday to reassure AT1 investors more broadly that they would take priority over shareholders in the event of future bank crises.

“Common equity instruments [stocks] are the first ones to absorb losses, and only after their full use would additional tier one be required to be written down,” the EU regulators said in a statement. “This approach has been consistently applied in past cases.”

Christine Lagarde, president of the European Central Bank, said in a speech Monday that banks in the eurozone had “a very limited exposure” to Credit Suisse, particularly in relation to AT1 bonds.

“We’re not talking billions, we’re talking millions,” she said.

The Bank of England said that “holders of [AT1s] should expect to be exposed to losses” when a bank fails according to their usual ranking in the capital hierarchy.

What now for investors?

The legal basis for the Credit Suisse losses may be contested. Quinn Emanuel Urquhart & Sullivan, a litigation firm headquartered in Los Angeles, said Monday that it had assembled a team of lawyers who were discussing options with Credit Suisse’s AT1 bondholders.

The surprise move by the SNB has rattled Europe’s AT1 bond market, with investors now questioning whether their holdings could be obliterated if another bank collapses.

Joost de Graaf, co-head of European credit at Van Lanschot Kempen, a Dutch wealth management firm, told CNN that his fund did not invest in AT1s because he was “afraid [of] something like this,” where regulators could decide that a bank was no longer viable and write down the bonds’ value.

“For the coming few years, [the AT1] market is going [to go] into some kind of a hibernation probably, where new AT1s will be very hard to place for issuers at acceptable levels,” de Graaf said.

The impact will likely spill over into the wider bond market, he added, with investors demanding higher yields for bonds now seen as riskier.

“For the foreseeable future, [banks’] funding [through bonds] will be more expensive,” de Graaf said.

There are signs that shift may already be happening.

Invesco’s AT1 Capital Bond exchange-traded fund, which tracks AT1 debt, is currently trading down 5.5% compared with last Friday’s close. WisdomTree, another AT1 ETF listed on the London Stock Exchange, fell 7.4% in afternoon trade.

But the real damage is the precedent the write-down may have set, said Benamou of Axiom Alternative Investments.

“No financial analyst had ever believed that AT1 bonds would be brought to zero… given the level of solvency of Credit Suisse… [and] pretty high level of regulatory capital,” he said.

— Mark Thompson contributed reporting.