UBS’s arranged takeover of Credit Suisse involved heavy losses for the latter bank’s shareholders.
But a more controversial part of the deal is the total write-down of bonds designated as additional Tier 1 (AT1) – also commonly known as contingent convertible (CoCo) bonds – while shareholders will receive more than $3bn.
This imposition of losses on these bondholders inverts the usual hierarchy in which shareholders take losses before bondholders because the terms of the bonds in question contained provisions that allow for a total write-down in a "viability event".
But that is the nature of CoCo bonds. They are designed to absorb losses to bolster a bank’s capital ratio, and avoid a bailout funded by taxpayers. Investors have been earning additional yield to compensate for this risk, as shown in the exhibit below.
Chart 1: CoCo bonds offer additional yield to compensate for their unique risk profile
Source: MSCI
Since regulators introduced this type of loss-absorbing bond to promote financial-system safety after the 2008 Global Financial Crisis, there have been only a few cases when write-down or conversion to equity has been triggered (notably when Banco Santander SA took over Banco Popular in rather similar circumstances). This may have lulled investors into a false sense of security about AT1 bonds’ risks, which Credit Suisse bondholders learned are very real.
Can the risks be measured?
CoCo bonds' loss-absorption mechanics are complex and somewhat untested – which presents challenges in measuring and managing those risks. An important feature is that AT1 bonds’ loss-absorption risk increases just as the capital position of a bank deteriorates. To capture this risk, which is called “negative convexity,” MSCI’s model for AT1 bonds makes the equity of the issuing bank an explicit risk factor.
As the exhibit below shows, on 16 March Credit Suisse’s AT1 bonds displayed elevated risks due to their equity exposure. Traditional risk management focusing on credit-spread risk would have missed the elevated, CoCo-specific risks.
Chart 2: Equity risk became the primary source of risk for Credit Suisse’s AT1 bonds
Source: MSCI
Following the collapse of Credit Suisse, AT1 bonds issued by BNP Paribas SA also displayed higher equity risk, reflecting the heightened sense of risk in the overall coco-bond market.
Gergely Szalka is senior researcher, product owner, at MSCI
