SOME $A25 billion worth of Credit Suisse “additional tier one” (or AT1) bonds have been written down to zero value as part of a rescue deal that favoured equity shareholders.
That’s caused anger among bondholders who have lost their money – and fears of wider fallout among investors around the world.
Are broader fears justified? What can Australian fixed income investors learn from the crisis?
AT1 bonds – also known in Europe as CoCos (contingent convertible bonds) and in Australia as bank hybrids – were created in response to previous financial crises, including the European debt crisis in 2011.
They are a type of bond that can be converted into shares if a certain event happens – and are often used by banks to meet their capital requirements.
The bonds can be converted into either common equity or written down to help absorb losses.
All 13 of In Credit Suisse’s outstanding CoCos – worth a combined face value of US$17.3 billion ($A 25.7 billion) – are of the write-down variety.
It isn’t unreasonable that these bonds are now worth zero. This part of the capital stack was designed to provide a buffer when the going gets tough.
But bondholders are outraged because equity holders will get paid more than CoCo holders on the bottom rung of the bond ladder.
That hasn’t always been the case.
In 2017, Spanish lender Banco Popular SA suffered a loss of some 1.35 billion euros
Regulators forced the bank to write off its CoCos – as well as its equity.
The Swiss regulator’s decision to write down a far larger amount of Credit Suisse CoCos — while retaining some (albeit small) value in its stock — sends a signal that things are murkier than we thought further down the capital structure.
The European CoCo market has a face value of $US275 billion. The instruments are perpetual in nature and have no maturity date.
Instead, they have call dates when issuing banks may choose to buy them back.
A “call” is financial jargon for having the option to buy a security at a pre-set price.
In the case of CoCos, it’s the issuing banks that have this option, not the bond holders.
The issuing banks should only want to buy back these CoCos at the call dates if they can do so below the prevailing market price or issue new CoCos at a cheaper level.
A “gentlemen’s agreement” between banks and investors means call dates are usually honoured (typically five to 10 years from the issue date) — and the securities are valued as if those call dates are hard maturity dates.
As recently as October 2022 we have seen in Australia’s bank T2 market that those call dates shouldn’t be viewed as maturity dates.
The Australian regulator was keen to remind issuers and investors alike that the economics needs to make sense for banks to call existing T2 paper.
While APRA has allowed T2 and AT1 bonds to be called since then, the immediate aftermath in Q4 2022 was a revaluation of existing low-coupon, subordinated bank paper to new and longer assumed maturity dates.
The time value of money dictates that when you get your principal back later than you originally thought, the value of that investment in today’s terms has to fall.
Australian T2 bank bonds had a volatile fourth quarter last year.
European bank debt traders are faced with a revaluation exercise this week as they try to factor in an increased write-down risk across the asset class, while also reassessing the value of the “gentlemen’s agreement” on call dates.
Since these CoCo bonds can also skip or defer coupon payments, their utility in providing steady income streams will also come into question.
Australian bank hybrids are designed to do the same job as European CoCos.
They are close to the bottom of the capital stack (next to equities) and are there to absorb losses for banks when they get in trouble.
The terms and conditions on our hybrids are a little different than CoCos. Most of our hybrids are convertible into common shares.
The big difference is the investor base that holds Australian hybrids.
AT1 bonds issued by European and US banks have large minimal parcel sizes for investors.
This is the regulators’ way of acknowledging the highly risky nature of these securities.
Only large wholesale or institutional investors are able to invest in hybrids offshore.
If mums and dads want exposure, they’ll likely have to invest in a fund or ETF that targets investing in hybrids.
This, at least, would get them some diversification benefit versus putting all their eggs in one basket.
In Australia, retail investors are the primary audience for hybrids.
Minimum investments for CoCos are small, to allow mums and dads to directly access this asset class.
The CoCo protestors in the Credit Suisse case are banks, hedge funds and big private wealth clients all chasing yield over the last decade.
The ones left holding the bag if any of our Aussie banks get into trouble would be retirees thinking they had bought “safe” bonds.
Fortunately, the Australian financial system and banks are in rude health, thanks to the relatively risk-averse nature of our banking and regulatory institutions.
Our regulator and central bank have a huge library of “dos and don’ts” to draw upon from offshore crisis experiences.
That was one of the reasons the RBA was able to pull out the stops of quantitative easing and the term funding facility so quickly in the initial throes of the COVID pandemic.
Nevertheless, the wiping-out of Credit Suisse AT1 bondholders will be a wake-up call for parallel assets in Australia.
In coming days, the market will be rightly asking whether the risks have been adequately priced in to domestic subordinated bank bonds.
Is the market making the right assumptions about call dates and maturity dates?
Do hybrids pay enough extra coupon for the risk that those coupons might be switched off?
Are there ways to construct portfolios that offer better sleep at night?
At the very least, the premium investors will demand of the next hybrid bond to be issued in Australia ought to be higher.
At Pendal, we’ve long maintained that hybrid bonds are not fixed income.
Fixed income investors demand stable and reliable income streams, with the benefit of diversification.
Diversification counts the most when the system is under stress.
Hybrids may look like fixed income when markets are calm. They look like equities (or worse!) when volatility picks up.
The worst part? By the time this becomes obvious, hybrid investors may not be able to find an exit.
More than ever, we believe it is time to take fixed income back into portfolios and scrutinise its true-to-label behaviour.
Pendal’s income strategies have never relied on hybrids for additional income, even when yields were glued to the floor.
That means today, our strategies don’t have to worry about the potential revaluation hole that awaits the asset class.
Instead, these strategies have been employing a highly active approach to managing interest rate risks around a safe and liquid core investment grade portfolio. That’s exactly what’s been needed as bond volatility reaches decade-highs.
Amy is Pendal’s Head of Income Strategies. She has extensive experience and expertise in emerging markets, global high yield and investment grade credit and holds an honours degree in economics from Cambridge University.
Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia. In 2021 the team won Lonsec’s Active Fixed Income Fund of the Year Award. In 2020 they won the Australian Fixed Interest category in the Zenith awards.
The team oversees some $20 billion invested across income, composite, pure alpha, global and Australian government strategies.
Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.
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