The Swiss regulator on Sunday announced that it was writing the value of Credit Suisse’s additional Tier 1 bonds — also called AT1 bonds, or contingent convertible bonds or CoCos — down to zero, as part of the bank’s merger with UBS.
The news has spooked investors of the AT1 market, which is valued at about $275 billion.
For more: The $275 billion bank convertible bond market thrown into turmoil after Credit Suisse’s securities wiped out
But what are Cocos and why should you care? Here’s what you need to know:
CoCos, or contingent convertible capital instruments, to give them their full name, are hybrid capital instruments that are structured to absorb losses in times of stress. They were introduced after the 2008 financial crisis to help steer risk away from taxpayers and onto bondholders.
They are bonds that automatically convert into equity—shares in the bank—when a bank’s capital falls below a certain threshold.
If a bank is functioning normally, investors are paid a coupon, just like any bondholder. But if things go wrong, the bank can “bail in” the CoCo investor, converting debt into shares in what would then be a troubled lender.
Also read: Saudis, Qataris and Norway to see big losses on UBS deal for Credit Suisse
European banks liked to issue CoCos, because they are counted as additional Tier 1 capital. They’re a way for banks to improve their capital ratios, as required under rules put in place after the crisis, without issuing more shares.
U.S. banks don’t issue CoCos—they use a different type of preferred stock to boost their Tier 1 capital. But U.S. investors have been buyers of CoCos for the extra yield they have offered. That’s risky because the instruments can be converted to low-value shares, or entirely wiped out as has now happed with those issued by Credit Suisse
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CoCos are perpetual bonds, or bonds that have no set maturity date. They can be redeemed if a bank exercises an option to do so, typically after a five-year period. But regulators may block banks from redeeming them, if the cost of issuing replacement debt is much higher. And if a bank becomes highly stressed like Credit Suisse, they can simply be written off.
A call for Credit Suisse bondholders is expected to take place on March 22, according to law firm Quinn Emanuel Urquhart & Sullivan, which said on Monday it is exploring potential legal actions on behalf of AT1 bondholders.
The surprise for some investors on Monday is that the Swiss move has wiped out the bondholders but not the shareholders, even though bondholders typically rank above equity holders in capital structure.
Not the Credit Suisse CoCos, which were structured to allow for the Swiss regulatory move.
Under the terms of the deal with UBS, Credit Suisse shareholders will be able to exchange their shares for about 0.70 francs, which is below where the stock closed Friday, but more than the bondholders will receive.
Most of the demand for CoCos in recent years has come from private banks and retail investors, especially in Europe and Asia, along with big U.S. institutional investors who were attracted by the higher yields in the low-interest-rate environment that prevailed from the crisis until the Federal Reserve started raising interest rates last year.
To be sure, the Credit Suisse CoCos were showing signs of stress last week as the bank became more embroiled in crisis. The bank’s 9.75% coupon CoCo bonds due June of 2028 were trading at an average price of 36 cents on the dollar last Wednesday, as MarketWatch’s Joy Wiltermuth reported.
Now fund managers say investors are likely to avoid them, undermining their use for banks.
“The UBS-CS deal might have avoided an immediate risk event, but the AT1 write down has added an uncertainty which could persist for weeks if not months,” said Mohit Kumar, chief financial economist in Europe at Jefferies.
“Given the large amount of AT1s outstanding, this would also raise the prospect of losses for other investors and the ability of banks to use them as a funding source in the future,” he added.
