Sam Slator – published by FundCalibre – 23 March 2023

It’s not often the Swiss Central Bank makes headlines. It is even more rare that bonds are a subject of breaking news.

But both were the main topic of conversation this week after the Swiss Central Bank sent shockwaves through bond markets when it wrote down some of Credit Suisse’s bonds to zero.

What happened? Why was it a shock? And what does it mean for bond holders? We try to explain…

Why has Credit Suisse’s share price fallen?

Credit Suisse shares have been under pressure for some time. The company has managed to find itself in embroiled in scandals almost annually that have hit both the bank’s reputation and its bottom line. It was not a profitable group by some margin.

Things came to a head a couple of weeks ago when the bank announced “material weakness” in its financial reporting. The share price plummeted, and the Swiss Central Bank had to set in to stop one of the country’s biggest and oldest banks from failing.

What did the Swiss Central Bank do?

To ‘save’ Credit Suisse – or rather stop contagion in the banking sector – the Swiss Central Bank agreed an emergency deal for another Swiss bank, UBS, to buy its stricken rival for 3 billion Swiss francs – a deal which meant that Credit Suisse shareholders received the equivalent of just 0.76 Swiss francs in UBS shares for stock that was worth 1.86 Swiss francs on the  previous trading day.

Another part of the deal – and the part that shocked investors – was that the Swiss authorities also said that AT1 bondholders would receive absolutely nothing.

“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.

What are AT1 bonds?

AT1 bonds were created after the Global Financial Crisis in 2008 as a way for failing banks to absorb losses, making a taxpayer-funded bailout less likely.

In a company’s capital structure, they are the riskiest bond you can invest in. This is because if a lender gets into trouble, this class of bonds can be quickly converted into equity or written down completely.

But because they are higher-risk, AT1s also offer a higher yield than most other bonds issued by the same borrower. So, for example, if Barclays Bank – which is seen as a very secure financial institution – offers an AT1 bond at say 4% yield vs another bond at 2% yield investors have seen this as somewhat of a ‘no-brainer’ in the past.

Why was the market shocked?

If investors have always known that these bonds were risky and could be converted to equity and written down to zero, why was the market shocked?

Well, it’s not the write-down itself that is the shock but the fact that the banks shareholders still have some value in their shares when these bond holders will not. What is supposed to happen is that shareholders lose their capital first, then AT1 holders.

In other words, the move was at odds with the usual hierarchy of losses when a bank fails.

What happened next?

As you might expect, other AT1 bonds lost value as investors worried that the same could happen to them.

So, in a swift move to calm markets, the European Banking Authority (EBA) and Bank of England) (BoE) were quick to come out and reassure markets on the merit and hierarchy of AT1s and European Central Bank (ECB) President, Christine Lagarde, went one step further in her direct rejection of Switzerland’s approach stating that “Switzerland does not set standards in Europe”.

In the ensuing days, this seems to have calmed fears in the market and AT1s have rebounded.

What do the bond fund managers say?

The team at TwentyFour Asset Management, whose Dynamic Bond, Corporate Bond and Absolute Return Credit funds are rated by FundCalibre, commented: “AT1s fell sharply on Monday. Nonetheless, the importance of the European and the UK’s regulatory rebuttal to the weekend’s proceedings became apparent as post their respective statements, a quick rebound took place and by the end of the session roughly half of the move down had been recovered. The positive momentum has continued through yesterday and this morning with some bank AT1 bonds now back to last Friday’s prices – i.e. recovering all of the post-Credit Suisse action, but still lower than pre the US regional bank led sell off.

“The situation is still fluid and of course we are keeping a very close eye on both banking fundamentals and market moves going forward, however we have been very reassured by both the statements from the EBA and BoE and by the way the AT1 market has functioned, particularly in the wake of the regulatory rebuttal on Monday.”

Alexander Pelteshki, co-manager of Aegon Strategic Bond fund was less surprised than the market saying: “We feel that the market angst following its absorption by UBS was somewhat misplaced; it was already clear for several days during the past week that in each of the three most likely outcomes for the distressed situation (a sale, a nationalisation, and a breakup), the AT1 capital stack was going to be impaired. The fact that there was a residual value in the bank’s equity rather than in its AT1 bonds seemed to have taken centre stage for a few moments, but it does not change the fact that the Credit Suisse AT1 bonds had few positive prospects.

“To be clear, the Swiss regulatory regime that covers, amongst other things, the treatment of AT1s in a bank’s capital stack, was always much riskier compared to the rest of the EU (and the UK). You need only to look at the terms and conditions of the Credit Suisse AT1s to see that “Notes could be cancelled in whole or in part prior to the cancellation of any or all of
CSG.”

“In simple terms, Credit Suisse AT1s could be (and were) zeroed before any loss on the firm’s equity was imposed. This is materially different from how these instruments are treated in the rest of the European Union and the UK (which essentially is the rest of the AT1 market).

“Just like any other investment, proper fundamental credit research helps identify weak borrowers in any sector. Swiss AT1s will continue to be inherently riskier than EU or UK AT1s. We suspect that going forward this risk might be better reflected in their price, but markets have a short memory. Time will tell.

“For the rest of the AT1 market beyond Switzerland, the simple story is that this changes little. And, after several days of mayhem, we are left with an AT1 market that offers a tremendous opportunity.”

Jim Leaviss, manager of the M&G Global Macro Bond fund concluded: “The key question markets are now trying to answer is the extent to which the recent issues in the banking sector are systemic or idiosyncratic. On the face of it, the issues appear to be idiosyncratic. Silicon Valley Bank (SVB) had suffered sharp losses on its unhedged long-dated government bond holdings, while it had a largely uninsured deposit base which was heavily concentrated in tech start-ups. Credit Suisse had been involved in a series of scandals over the past few years and had reported heavy losses – this had damaged confidence in the bank and led to a flight in deposits.

“However, it is clearly impossible to disentangle recent developments from the actions of central banks. The Fed [US central bank] has been hiking rates aggressively and tightening of this scale has historically been associated with crises within the financial sector. Markets are clearly worried about the impact of further rate hikes. The Fed will need to take note of this given the key role they play in maintaining financial stability.

“On a more positive note, we think central banks will do whatever it takes if we see further contagion, whether this be a pausing in hikes, further quantitative easing or bailouts. Given the fragility of the global economy, we do not believe policymakers will have the appetite to stand aside and allow things to deteriorate. The situation is fast moving, and it is difficult to say how events will unfold from here, although it does feel like a changing point in the cycle, and we are perhaps now approaching the end of the Fed’s current hiking agenda.”

_{Photo by Janosch Diggelmann on Unsplash}

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