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Since March 2022, the US Federal Reserve has consistently raised interest rates, prompting a shift in market sentiment. Investors seeking higher returns than bonds turned to banks, triggering a mass bond sell-off and subsequent price decline. However, by Q4 2023, expectations of a more accommodative stance from the Fed led investors back to the bond market, anticipating gains as prices rebound at the end of the rate hike cycle.
In 2023, global financial markets faced turbulence, marked by the collapse of Silicon Valley Bank and a crisis at Credit Suisse. UBS Group’s acquisition of Credit Suisse unexpectedly led to the cancellation of all previously issued Credit Suisse Additional Tier-1 (AT1) bonds, causing substantial losses for investors. While some stability returned with Sumitomo Mitsui Financial Group’s successful sale of $1 billion yen-denominated AT1 bonds, the Credit Suisse incident remains a market focal point.
This article explores the nature of AT1 bonds, why investors engage during interest rate hikes, the impact of bond cancellations, and strategies to avoid pitfalls, shedding light on the hidden risks behind their high yields.
In 2023, UBS Group’s acquisition of Credit Suisse unexpectedly led to the cancellation of all previously issued Credit Suisse AT1 bonds. However, looking at the bank’s capital redemption order, stocks have the lowest priority for redemption; even in the case of cancellation, stocks should be addressed first. This move surprised the market. Nevertheless, AT1 bonds have their uniqueness; although categorized as bonds, their issuance reasons and conditions differ significantly from commonly seen bonds.
AT1 bonds, or Additional Tier 1 Capital Bonds, fall under the category of Contingent Convertible bonds, also known as CoCo Bonds. CoCo Bonds serve to avert a bank’s operational crisis that could lead to bankruptcy due to a rapid increase in liabilities. In times of crisis, CoCo Bonds can be forcibly converted into common stocks, allowing bondholders and shareholders to share losses, thereby reducing the debt ratio and obtaining more substantial capital buffers. This mechanism prevents the escalation of systemic risks and safeguards the entire financial system.
Basel III, published by regulatory authorities in 2010, imposed stricter regulations and mandated systemically important banks to meet capital requirements. AT1 bonds represent a form of Total Loss Absorbing Capacity (TLAC) and are part of Basel III’s stipulation for “banks issuing long-term debt instruments with conversion terms to common stocks,” aimed at absorbing losses in times of crisis. These instruments contribute to minimizing the impact on the overall market during periods of bad debt or bankruptcy risks.
CoCo Bonds can be categorized into T2 and AT1 types based on their product structure. T2 bonds have a specified maturity date, while AT1 bonds are perpetual, with no expiration. Since the primary purpose of AT1 bonds is to absorb losses, and T2 bonds are intended for liquidation when a bank ceases operations, AT1 bonds have a lower trigger threshold and lower priority in the liquidation hierarchy than T2 bonds.
In normal circumstances, AT1 bonds are similar to regular bonds. However, when the issuing bank faces an operational crisis, the principal may be written down or converted into common stock. For example, writing down the principal means the bank redeems the bonds, reducing the burden of future interest payments and principal repayments. Conversion into common stock allows investors to become shareholders, sharing losses and protecting the bank from bankruptcy due to insufficient capital. Therefore, according to Basel III, if a bank is in a loss situation or its capital falls to a certain level, AT1 bonds may suspend interest payments without default, unlike T2 bonds, which must continue interest payments to avoid default.
Due to the risk of bank failure, CoCo Bonds generally have lower liquidity compared to regular bonds. However, they offer higher interest rates to investors. To anticipate a bank’s operational crisis, observing whether a bank chooses not to redeem CoCo Bonds during the redemption period can be indicative. Before a crisis occurs, the bank may already lack the surplus capital to redeem the bonds. TEJ’s bond database includes information on whether a bank has redeemed bonds, providing investors with valuable insights for evaluation.
The distinguishing factor between CoCo Bonds and commonly seen convertible bonds lies in their conversion mechanisms. CoCo Bonds have an automatic conversion mechanism triggered when a bank’s capital falls below the required level, forcibly converting the CoCo Bonds held by investors. Essentially, investors have no choice in the matter. In contrast, regular convertible bonds allow investors to decide whether to convert when the triggering conditions are met. Due to these differing conversion mechanisms, the two types of bonds have distinct positions in the market.
The full cancellation of Credit Suisse’s AT1 bonds can be traced back to the prospectus of conventional bonds. In addition to providing basic information such as name, tenure, interest rate, etc., the prospectus outlines redemption conditions or other events that may lead to default or cancellation.
In this case, Credit Suisse’s issuance of AT1 bonds included a “Viability Event” clause in the prospectus. This clause stated that when regulatory authorities deem the bank incapable of sustained operation with insufficient capital, the AT1 bonds can be directly written off to zero. It doesn’t involve converting the bonds into common stock or reducing the principal through bond redemption to lower future interest payments. Instead, it directly cancels the bonds. With equity still intact, the held AT1 bonds become worthless, and the redemption priority of common stock even surpasses that of AT1 bonds. This implies that after Credit Suisse’s acquisition, Credit Suisse stock still holds some value, but AT1 bonds are rendered entirely meaningless.
In the context of the recent events, the Swiss Financial Market Supervisory Authority (FINMA) made the strategic decision to prioritize the interests of AT1 bond investors over common stock shareholders. This move triggered a market backlash. Despite subsequent joint statements from European regulatory bodies attempting to reassure the market by labeling it an exceptional case, AT1 bondholders persist in protecting their rights and interests.
Despite the high issuance cost, Taiwan has yet to see banks issuing CoCo bonds. How is the situation with AT1 bond issuance in other countries?
According to the Financial Stability Oversight Council (FSOC) research, U.S. banks prefer issuing preferred stocks over CoCo bonds to meet capital requirements. The U.S. government is hesitant about AT1 bonds. Regulatory factors contribute to the limited issuance of AT1 bonds in the United States, with reasons including:
Due to regulatory support and tax incentives, Europe and China currently lead in CoCo bond issuance. Both T2 and AT1 bonds are preferred instruments for supplementary capital in these regions. Examining 199 Chinese-issued AT1 bonds in TEJ’s database, most issuers are banks, with a few from asset management and investment companies. Notably, the major Chinese banks issuing AT1 bonds include Industrial and Commercial Bank of China, China Construction Bank, Bank of China, and Agricultural Bank of China. The regulatory environment and tax incentives have contributed to the popularity of CoCo bonds in China.
AT1 bonds are characterized by high risk and high interest rates. Take the Credit Suisse’s AT1 bonds as example, it flaunted a 10% coupon rate, a bold move to match its risk profile. But why would anyone be drawn to this financial rollercoaster? Here are two reasons.
Firstly, if the issuance rate is higher than subordinate and unsecured senior bonds, it significantly enhances attractiveness to investors. Secondly, since banks issue AT1 bonds, these banks typically boast strong credit ratings and often hold the status of globally systemically important banks. Subject to stringent regulatory requirements and supervision, investors find them trustworthy and reliable, justifying their investment.
In Taiwan, the Financial Supervisory Commission annually releases a list of designated Domestic Systemically Important Banks (D-SIBs). In 2023, there are six banks on the list, including CTBC, Fubon Bank, Cathay Bank, Taiwan Cooperative Bank, Mega Bank, and First Commercial Bank. These banks must comply with domestic capital requirements and pass stress tests, ensuring trustworthiness for potential investors.
In Taiwan, regulatory adjustments by the FSC in late 2021 restricted various fund types from investing in CoCo bonds. These restrictions include mandatory minimum credit ratings and total investment amount limitations. Capital-guaranteed funds are explicitly prohibited from CoCo bond investments due to their conservative nature.
Following the Credit Suisse AT1 bond incident, FSC statistics reveal that regulatory constraints have dissuaded Taiwan’s financial, insurance, and securities industries from AT1 bond investments. However, wealth management departments recommended professional investors to directly hold these bonds, impacting 77 clients. While domestic funds avoided direct investments in Credit Suisse AT1 bonds, foreign funds held a negligible portion. With less than a 0.1% share of the total assets under foreign funds, the impact on the overall market remains minimal.
Despite the cancellation of Credit Suisse’s AT1 bonds in March 2023, there is no indication that the market has ceased issuance. In April, Japan’s Mitsubishi UFJ Financial Group successfully issued AT1 bonds, and even Credit Suisse’s acquirer, UBS Group, inquired in September about investor interest in issuing the first AT1 bonds post-acquisition. Following this event, central banks worldwide have reiterated that asset liquidation priorities will not change arbitrarily. UBS Group has made slight adjustments to trigger conditions to ensure that a similar Credit Suisse AT1 bond storm does not recur.
Investors must exercise caution and thoroughly review prospectuses when investing in related bonds to assess risks. TEJ compiles information on bonds from Greater China, Japan, and South Korea, detailing issuance information such as bond name, face value, total issuance, currency, and more. TEJ provides users with high-quality information through a convenient and clear interface for easy aggregation and retrieval of information.
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