Impact on Fixed income funds with exposure to AT1 CoCos

The Swiss authorities (government, SNB and FINMA) orchestrated during the week-end the takeover of Credit Suisse (‘CS’) by UBS.  UBS agreed to buy Credit Suisse for ~$3bn while the Swiss National Bank agreed to offer up to $110bn liquidity line to UBS.

This will provide sufficient liquidity to carry out the takeover and it will be possible to continue all the business activities of both banks with no restrictions or interruptions.

The outcome for CS bondholders varies depending on their position in their capital structure with all of CS senior debt (holdco and opco) being assumed by UBS (moving from BBB rated entity to A), whilst the AT1 got zeroed out under a controversial decision by the Swiss regulator to write them down, whilst allowing shareholders to be compensated. The T2 CoCo (6.5% 23s) have been spared and should also be transferred to UBS (from junk rated to IG).

The extraordinary government support will trigger a complete write-down of the nominal value of all AT1 shares of Credit Suisse in the amount of around $17 billion, and thus an increase in core capital.

The takeover will result in UBS becoming the second largest wealth manager with $5tn AUM, undisputed leader in Switzerland and its bigger size will require higher capital buffers. FINMA will grant appropriate transitional periods for these to be built up. The construct of the transaction provides UBS with a significant $25bn of downside protection supplied by the Government, to allow for a prudent downsize of CS’s Investment Banking business and restructuring of the combined entity.

GAM

• • GAM Star Credit Opportunities (EUR): 0.66% to the AT1 + 0.5% in Seniors
  • GAM Star Credit Opportunities (USD): 1.88% to the AT1

Comments from the Manager (AtlanticOmnium): The write-down of CS’ AT1s is an idiosyncratic event which should have no read across to other high quality banks. Regarding the write-down of AT1 CoCos, they have always been the most subordinated part of the capital structure and thus carried incremental risks compared to other types of subordinated bonds, with for example higher coupon risk and explicit write-down triggers that can be used even if outside of a bail-in.

The funds are and have always been positioned conservatively in respect to the allocation of AT1s, with around 20% in the USD fund and 30% in the EUR and GBP funds of allocation to AT1 CoCos – the rest being in other bonds that rank senior to AT1 CoCos, such as Tier 2s and seniors for example.

Despite the CS situation and the uncertainty it creates, national champions within European banks remain extremely well capitalized. Spreads have widened significantly over the past weeks and seemingly yesterday.  As of Friday, the market has significantly re-priced to maturity, with close to 100% of the AT1s assumed not to be called. Concurrently, CS is tendering for up to CHF3bn of senior bonds, 5/6pts above yesterday’s market levels. Although we are not directly involved in those instruments, the tender plus positive news flow has led to positive price action on the bonds of CS, with the AT1 CoCos up by around 5 to 7 points in early trading yesterday.

PIMCO

• • PIMCO GIS Capital Securities: 3.42% to the AT1 + 0.45% Senior Holdco

  • PIMCO GIS Global Investment Grade Credit: 0.17% in the AT1 + 0.47% Senior Holdco + 0.85% Tier2 CoCo

  • PIMCO GIS Diversified Income: 0.10% in the AT1 + 0.05% Senior Holdco + 0.64% Tier2 CoCo

Comments from the Manager (20/03/2023): Credit Suisse experienced a crisis of confidence which had manifested in considerable outflows of client funds. This was intensified by the upheavals in the US banking market over the last few weeks.  We did believe that CS made important steps forward with respect to its radical overhaul, particularly in relation to its efforts to cut costs (8% reduction in workforce), strengthen its capital base ($4bn equity raise) and de-risk its balance sheet as well as selling assets (e.g., SPG to Apollo for $800m or >30bp CET1). However, the bank had not managed to stem fully the outflows.

We also thought there was significant execution risks entailed in CS’ restructuring plan but even FINMA and the Swiss National Bank confirmed in the middle of last week that “Credit Suisse meets the higher capital and liquidity requirements applicable to systemically important banks” and so we are surprised to see a positive equity value but the AT1s be written down.  This is something we expect to be challenged but ultimate recovery is very uncertain at this time.

The swift and comprehensive actions by the regulators in the US and Europe highlights how policymakers have learned both from their experiences in 2008 and 2020 that moving fast, big, and arguably pre-emptively can help to reduce contagion risk. That being said, we do expect volatility in the AT1 market given the losses for this set of bondholders.

Invesco

• • Invesco Global Investment Grade Corporate: 0.06% in the AT1 + 0.36% Tier2 + 0.83% Senior

Vontobel

• • Vontobel TwentyFour Strategic Income: 0.50% in the AT1

Comments from the Manager (20/03/2023): The ramifications of the actions of the Swiss authorities last night are likely to have consequences for bank debt markets for years to come. A Global Systemically Important Financial Institution has essentially failed to carry on as a going concern, and FINMA, the Swiss regulator, has overseen a payment to equity holders (bonuses also being paid, apparently), while AT1 debtholders are wiped out, which is unprecedented. The situation is very fluid, but our early thoughts are as follows:

Firstly, we believe that the Swiss regulators have ripped up the rules for investing in a company. Equity is obviously the most subordinated security in a capital structure, nevertheless, Credit Suisse equity holders got bailed out by UBS (along with government guarantees) while AT1 debtholders are written down to zero.  It has been reported that, apparently, the law was changed over the weekend, which allowed the liquidity facility, put in place last week, to be used as a reason to trigger a Viability Event. The most similar case that comes to mind is Banco Espirito Santo in Portugal some years ago where, in our and many market participant’s view, the Portuguese regulator failed to treat pari passu bondholders in an equal and fair manner – legal action was taken by bond holders and the process is still ongoing. The consequences for Portuguese banks were quite severe as they were in practice locked out of international capital markets for years.

Secondly, AT1 capital is supposed to be “going concern capital”. That means they would get triggered into equity at a given CET1 level (generally 7% for Swiss banks), giving the issuer an automatic capital injection thereby allowing it to continue to be “a going concern”. In a more severe case, where the entity completely failed to remain a going concern, then the AT1s would be written down, but also along with the Tier 2 bonds and other subordinated debt, given the latter are “gone concern” capital. In this scenario the equity is of course written down to zero. This is what happened with Spain’s Banco Popular some years ago, and in this case, investors did not question the decision (it had non-performing assets of ~30% and full loaded CET1 of ~7.3%).

Thirdly, as a consequence of the aforementioned, we are seeing subordinated debt trade down this morning, but other regulators having been quick to highlight the differences in their own regimes. The ECB has just hit the tapes, saying “the Great Financial Crisis has established, among others, the order according to which shareholders and creditors of a troubled bank should bear losses”, “In particular, common equity instruments are the first ones to absorb losses, and only after their full use would Additional Tier One be required to be written down”. It seems very clear to us; they think the Swiss regulators got it wrong.

Finally, we wonder what long term consequences this has for the Swiss financial system, as this action from FINMA will very likely dent investor confidence in this regulatory regime. Other banks have seen significant contagion, but even allowing for the statement already from the ECB, the laws governing the write-down or conversion of AT1s is enshrined across Europe via the Bank Resolution and Recovery Directive (BRRD) which sets out, by rule, that equity holders have to be wiped out and a valuation must be carried out before this power is used; the same rules continue to apply in the UK. Given the complexities of the European system, with every country having a vote, it would be almost impossible to get agreement to change laws in this manner in a short space of time.

BlueBay

• • BlueBay Investment Grade Euro Aggregate: 0.76% Senior debt

At this stage, we have monitored all the funds from our Selection List likely to have had exposure to the CS debts. The exposure to CS AT1s has been relatively contained in the portfolios, except for the PIMCO GIS Capital Securities fund, which is a pure subordinated financial strategy.

We also understand that the consequences of this event was hard to anticipate since the rules were changed over the weekend. It is therefore to be expected that legal actions will take place in the coming months in the same way as those taken in the case of the Banco Espirito Santo.

We will of course continue to closely follow the future developments on this topic and keep you informed with relevant comments from the portfolio managers we follow.