The Strategist

Credit Suisse AT1 wipeout - one year later

One year has passed since the Credit Suisse AT1 bond default. In this article, we take a look at the lessons learned from this banking crisis and examine the importance of subordinated bank bonds for investors.

Date
Author
Simon Weiss, Head Fixed Income Strategy LGT Private Banking Europe
Reading time
10 minutes

Credit Suisse
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It was a memorable Sunday evening on 19 March 2023, when the Federal Council, accompanied by representatives of the Swiss National Bank and the Swiss Financial Market Supervisory Authority (FINMA), as well as the respective chairmen of the boards of directors of UBS and Credit Suisse (CS), stood before the media and announced the merger of the two companies. Effectively, this was tantamount to a takeover of CS by UBS. 

Of particular relevance to the bond markets, which were already jittery due to the regional banking crisis in the US, was a measure ordered by FINMA that resulted in the complete write-off of Credit Suisse's Additional Tier 1 (AT1) capital of CHF 16 billion. In the immediate aftermath, it was unclear how far-reaching the consequences would be. To make matters worse, FINMA's action not only disregarded the traditionally respected capital hierarchy, with shareholders receiving a small residual value in contrast to AT1 holders, but also the fact that Credit Suisse's subordinated bonds only provided for a permanent write-down, with no possibility of conversion into share capital or subsequent revaluation, and thus differed from European structures.

Just over a year after the outright default of Credit Suisse's AT1 bonds, we note that the European subordinated bank bond market is in good shape. Credit spreads for subordinated bank bonds have returned to the levels we saw in early 2023, before the CS default. In the European context, it certainly helped that regulators there quickly made it clear that they would respect the capital hierarchy in a similar case and only trigger the default clause in the event of a full resolution. Although this is somewhat at odds with the original purpose of "going concern" capital, which was to absorb losses to enable a financial institution to continue as a going concern, it conversely strengthens the position of bondholders, who need only fear the total loss of their capital as an "ultima ratio". In summary, with the exception of Credit Suisse, European banks have weathered the market turmoil without significant losses.

What have we learned from the Credit Suisse episode?

A crisis such as the one we experienced last year can lead to a number of conclusions that are of varying relevance to all parties involved:

  • For bank management in particular, the lesson is that reputation and client trust are critical to long-term success, but also that the cause of a problem becomes irrelevant in a crisis of confidence.

  • For regulators, the realisation that liquidity can quickly become a problem in the event of a bank run, even if capitalisation and liquidity ratios are objectively sound. But also the realisation that the regulatory guard rails in the European Union and the United Kingdom left a much better impression than they did in Switzerland.

  • Last but not least, we conclude for investors that there is unfortunately no such thing as 100% security, as the example of the circumvention of traditionally respected capital hierarchies shows. Furthermore, when investing in individual bonds, reading and understanding the bond documentation can be crucial.

Subordinated bank bonds will remain relevant as part of the capital structure 

One year on from the collapse of Credit Suisse, the subordinated bank bond market is in solid shape. Although there was a great deal of uncertainty in the immediate aftermath of the CS default, we are now convinced that this bond category will retain its place in the capital structure of European banks.

From an investor's point of view, there is one new aspect that should be included in future risk assessments. In principle, the risks of subordinated AT1 bonds can be divided into three areas: 1) conditional capital loss, 2) coupon cancellation and 3) extension risk. While there have only been two defaults by European issuers since the introduction of the "new" AT1 structures in 2013 (Banco Popular in 2017 and Credit Suisse in 2023), the risk of a conditional maturity extension has been increasingly discussed in recent years in a rising interest rate environment. However, history has repeatedly shown that European banks repay their liabilities at the earliest possible date, unlike US institutions, which generally take a more economic view. With the exception of market phases in which refinancing is simply not possible due to literally closed markets, investors' exposure to extension risks appears to be rather limited.

We therefore conclude that the decision to invest in AT1 bonds should not be based solely on whether the additional risks taken compared to "normal" bonds are adequately compensated. Rather, the focus should be on whether the inherent volatility, which is an integral part of any AT1 bond, is adequately compensated.

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