Carmignac: Contingent Convertible Bonds come full circle

18 maart 2024

On 19 March 2023, UBS announced its acquisition of Credit Suisse. As the details emerged, one area in particular caused a stir: Credit Suisse was writing down its Additional Tier 1 contingent convertible bonds while its equity holders were to receive a CHF3bn payout, thus rejecting the usual repayment order. This triggered a wave of litigation, as well as a debate about the validity of the asset class. One year on, Pierre Verlé, head of credit at Carmignac explores the implications of this event and the outlook for AT1.

To understand the significance of the Credit Suisse case, we must consider the reason Additional Tier1 Contingent Convertible bonds were originally designed. In the wake of the great financial crisis, Contingent Convertible bonds (CoCos) were cooked up by regulators to help banks meet more robust capital requirements. In the instance of a crisis, they can be written-off (or converted to shares). The benefit for holders is considerably higher yields. And the benefit to the banking system is the recapitalisation of a fragile institution, the facilitation of a ‘crisis’ solution (such as an acquisition) and to help avoid a systemic crisis.

After a series of mistakes, Credit Suisse, a systemically important bank, lost the confidence of financial markets following the failure of three US banks. Given the nature of the crisis, its CoCos quickly entered the spotlight. In the days leading up to the acquisition announcement, the bank found itself surrounded by liquidity-crisis rumours. The CHF16bn write-off of the entire AT1 stack of Credit Suisse was undoubtedly a game changer to convince UBS to take the plunge. The challenge, however, was less the write-down of the AT1 CoCos, than the payment (in the form of UBS shares) to Credit Suisse shareholders, contrary to the  agreed seniority of repayments in the event of a crisis. Litigation continues, and the slight rebound in the price of Credit Suisse’s AT1 claims (which are now exchanged above 10% of their nominal value vs. less than 2% immediately after the announcement) suggests some distressed investors see a material probability  of a settlement.

For investors observing this situation, the question was, if financial institutions could disregard their repayment structure, placing shareholders above junior CoCos holders, was there any merit in owning these instruments over shares, their (supposedly) higher-return cousins?

In the wake of this event, AT1s took a hammering. On 20 March, the yield of the CoCo Index went briefly just above 10%, the highest level since its creation in 2013 and almost 3% more than three years earlier at the peak of the Covid panic.

But this panic missed the forest for the trees. Not only were several elements of the Credit Suisse acquisition unique, including the role and timing of a main shareholder and the Swiss regulatory framework, but more importantly, taking some perspective, the CoCos did what they were designed to do: facilitate a credible restructuring of a bank which had lost its most vital asset, its stakeholders’ confidence.

A crisis was avoided, despite the distress of a systemically important bank and medium-term contagion to other financial institutions was contained. Those convertible bonds worked as a circuit breaker, so that the cost of the run on the bank was essentially limited to Credit Suisse AT1 holders (and, to some extent, shareholders). Without a doubt the social cost of Credit Suisse’s fall was much lower than the average banking crisis.

Today, CoCos trade at roughly the same level, in terms of spread, as they did in February 2023. Credibility has been restored. And once again, investors are pricing a bond’s risks on the merits of each financial institution rather than a binary systemic risk. 

CoCos continue to play an important role in containing a potential crisis by helping shore up a bank’s capital. But furthermore, individual assessment of a credit opportunity is precisely the way a well-functioning market should work. CoCos are well and truly back on investors’ radars. And, subject to solid fundamental analysis of the individual security, those instruments represent an attractive way to access those quality banks that have worked hard to improve their financial stability since the great financial crisis.