Wipeout of risky Credit Suisse bonds upends $369 billion market

UBS' rescue of Credit Suisse included pulling the pin on 16 billion Swiss francs (S$23 billion) of contingent convertible bonds, or CoCos. PHOTO: REUTERS

LONDON – They are called contingent convertible bonds, or CoCos, and are often described as high-yield investments with a hand grenade attached.

The takeover of Credit Suisse by UBS Group included pulling the pin on 16 billion Swiss francs (S$23 billion) of CoCos, which are also known as additional tier 1 (AT1) bonds.

CoCos are the lowest rung of bank debt, meaning that while they produce juicy returns in good times, they are designed to be among the first to feel pain if a bank’s troubles get bad enough. The vaporising of Credit Suisse’s CoCo debt will strengthen the balance sheet of the newly combined bank – but could spell disaster for the wider US$275 billion (S$369 billion) CoCo market.

1. What is a CoCo?

Introduced after the global financial crisis, it is essentially a cross between a bond and a stock that helps banks bolster capital to meet regulations designed to prevent failure. CoCos are contingent in the sense that their status can change if a bank’s capital levels fall below a specified level; they are convertible because, in many cases, they can be turned into equity – shares of the bank – if the shortfall gets big enough. In other cases, CoCos are written down in whole or in part. This buffer of debt and equity is intended to prevent taxpayers from having to shoulder the bill for a bank’s collapse, with CoCos giving banks a bigger capital cushion amid concern in the aftermath of the global financial crisis that many were over-leveraged. For regulators, CoCos are a way for banks to be pulled back from the brink without the cost falling on taxpayers or existing shareholders.

2. How many did Credit Suisse have?

The Swiss lender’s holding company had 13 CoCos outstanding worth a combined 6 billion Swiss francs, issued in the Swiss currency, US dollars and Singapore dollars, according to data compiled by Bloomberg. This is just above 20 per cent of its total debt pile. Its biggest CoCos were denominated in United States dollars. CoCos are typically undated, meaning the bond has no defined maturity, but lenders can call for repayment normally after around five years. Investors price CoCos to their expected worth at their first call dates. When they are not called – in other words, when they are extended – prices tend to fall. The recent global market sell-off has driven corporate funding costs higher, meaning there is now a higher chance a lender could opt to skip a call because it could prove expensive to replace an existing note with a new one.

3. Why were Credit Suisse’s CoCos wiped out?

UBS has agreed to buy Credit Suisse in a government-brokered deal aimed at containing a crisis of confidence that threatened to cascade across global financial markets. Due to the extraordinary government support, it will trigger a “complete write-down” of the bank’s AT1 bonds to increase core capital, Swiss financial regulator Finma said in a statement on its website. In simple terms, banks need to meet a minimum requirement for the amount of their own funds and eligible liabilities to support an effective resolution in the event of a collapse. If a lender’s capital ratios fall below a predetermined level, then CoCos can be written down.

4. Why are some bond holders angry?

In a normal write-down scenario, shareholders are the first to take a hit before AT1 bonds face losses, as Credit Suisse also showed in a presentation to investors earlier last week. However, under the terms of the government-brokered deal, Credit Suisse shareholders are set to receive three billion francs.

This has provoked a furious response from some of the AT1 bond holders as it has not accounted for the seniority of CoCos over the lender’s shares in the capital structure. This is a big problem for a market that would expect bond holders to be paid before shareholders.

5. How does this impact the wider CoCo market?

The decision to ignore market convention – that shareholders are the first to take a hit before AT1 bonds face losses – could prove to be a huge blow to the US$275 billion AT1 market and raises serious doubts about the prospects for other lenders’ CoCos. To compound the misery, it is also the market’s biggest loss, far eclipsing the one other instance of a lender’s CoCos being wiped out. Back in 2017, junior bond holders of Spanish lender Banco Popular suffered an approximately €1.35 billion (S$1.9 billion) loss when it was absorbed by Banco Santander to avoid a collapse. Credit Suisse’s write-down is far bigger and must raise serious questions about what comes next for the market.

The huge uncertainty is likely to weigh on lenders’ bond prices right across the ratings spectrum. Uncertainty about the health of several lenders in recent weeks had already weighed on CoCo bond prices, with the average AT1 now indicated at a price of just 82 per cent of face value, one of the steepest discounts on record. Yields on Credit Suisse’s CoCos had surged to distressed levels in recent days. BLOOMBERG

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