Market volatility remains high in the banking sector as central banks work to dispel contagion fears. In the case of Credit Suisse, the Swiss National Bank moved swiftly and decisively in order to prevent contagion across the wider banking and financial services sectors. As a result, Swiss regulators wrote-off Credit Suisse’s $17 billion in additional tier 1 bonds (AT1) in the emergency take-over by rival Swiss bank UBS. While this write down was always theoretically possible, many investors were stunned when equity holders received value and AT1 holders were wiped out. Why was this a surprising move by regulators?
In order to understand why a full write down of its value is significant, it is important to understand European bank debt tiers and where AT1s fall within this hierarchy (exhibit 1).
Exhibit 1: Hierarchy of European bank debt tiers
Basel: Stipulates minimum capital levels for banks. As such, it dictates how much additional tier 1 and tier 2 capital a bank must have, in additional to common equity. Normally expressed as % of risk weighted assets.
MREL/TLAC: On top of the Basel capital requirements, MREL/TLAC rules dictates that the bank must have a certain volume of bail-inable senior debt (non-preferred or hold-co structure) that can be easily written down in order to recapitalize a bank in times of stress, to ensure it can continue to operate.
Source: Aegon Asset Management. As of March 28, 2023.
Additional tier 1, or AT1, securities were first introduced in the wake of the financial crisis in 2008. Considered just above equity in the capital stack, they are a key source of financing for many large European banks. They are intended to help banks improve capital positions to meet regulatory requirements, if needed. If the capital levels decline below the predetermined threshold, these securities can be written down in whole or part, temporarily or permanently, depending on the terms.
In addition, some of these securities involve a potential equity conversion (which was not the case for the Credit Suisse AT1s). Aside from the idiosyncratic nature of the Credit Suisse situation, AT1s can provide attractive investment opportunities as they can offer diversification benefits as well as attractive yield and carry for what is typically higher-quality bank exposure.
The broader AT1 market
Across jurisdictions, it is important to understand that there is a material difference in how these instruments are treated. The European Union and the UK, which comprises the bulk of the AT1 market, reassured investors that shareholders should face losses ahead of bondholders. This was confirmed by both the European Central Bank (ECB) (in conjunction with the Single Resolution Board (SRB) and European Banking Authority or EBA) and Bank of England on 20 March: “AT1 instruments rank ahead of [common equity tier 1] and behind [tier 2] in the hierarchy. Holders of such instruments should expect to be exposed to losses in resolution or insolvency in the order of their positions in this hierarchy.”
In the case of Credit Suisse, the Swiss regulatory regime allowed for Credit Suisse AT1s to be zeroed before any loss on the firm’s equity was imposed based on regulators interpretation that Credit Suisse had hit the PONV trigger (Point of Non-Viability). Although this outcome is disappointing for AT1 holders, it does appear that the regulator acted in accordance with provisions.
Bottom line? Not all AT1 securities are created equal as regulatory requirements vary across regions.
Opportunities remain in AT1s
Setting aside the idiosyncratic Credit Suisse situation, we see AT1s as solid long-term investment opportunities. Although they are not immune to short-term market swings, AT1s can provide attractive investment opportunities as they can offer diversification benefits as well as attractive yield and carry for what is typically higher-quality bank exposure.
While we believe the AT1 market will persevere and the European banking sector crisis should be contained, market sentiment is fragile. It is likely that markets will remain volatile as investors evaluate deposit and liquidity risk across the banking sector, as well as the broader implications of tighter financial conditions. This will likely lead to shorter term volatility, which could create interesting buying opportunities.
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