Contingent Convertible Bonds Since the Recent Banking Crisis

What are AT1 CoCos?

During the 2007–2008 Global Financial Crisis, governments bailed out banks that were deemed to be systemically important financial institutions. In response to the public and private capital used to support, merge or otherwise bail out many financial institutions, there was tighter regulation of the banking system.

In the U.S., the Dodd-Frank Act imposed tougher capital requirements and other rigorous testing requirements on banks. In Europe a similar new regulatory regime — the Basel Committee on Banking Supervision (BCBS) — was created to address capital and review procedures. In December 2010, the BCBS published the Basel III reforms to increase the quality of banks’ capital bases and the required level of regulatory capital. Basel III outlined the specific classification criteria for the components of regulatory capital.

Total available regulatory capital is the sum of Tier 1 capital, which includes Common Equity Tier 1 (CET1) capital and Additional Tier 1 (AT1) capital, and Tier 2 (T2) capital.

Banks are required to maintain specified minimum percentages of risk-weighted assets in CET1, Tier 1 and total capital to remain financially viable. CoCos can qualify as either AT1 or T2 capital, depending on the particular security structure. All AT1 securities are perpetual, so most CoCos are issued without a stated maturity date. U.S. banks do not issue CoCos to satisfy the AT1 capital requirements, but instead issue preferred shares.

There are two types of trigger event for CoCos to be used:

• A mechanical trigger is based on the issuer’s regulatory capital levels. It is activated when the issuer’s CET1 ratio falls below 5.125 percent or 7 percent of the total risk-weighted assets, depending on the prospectus.
• A discretionary trigger is reserved for bank regulators to declare a “point of non-viability” (PoNV) solely based on the regulator’s judgement about the issuing bank’s ability to continue operating.

AT1 CoCos also have a loss-absorption mechanism that occurs through either a conversion of the CoCos to common equity at a predetermined conversion ratio or a permanent or temporary write-down of the principal.

The majority of AT1 CoCos are issued by European financial institutions with an investment-grade issuer rating and are denominated in USD. However, due to the bonds’ subordination in the typical bank capital structure (AT1 capital sits just above the common equity), the typical ratings for the AT1 CoCos are BB/BBB-. This position in the debt subordination structure provides higher yields and lower bond ratings, compensating AT1 debt holders for assuming additional risk. Investors in CoCos are compensated for this risk with yields that are closer to high-yield bonds, and higher than yields available on comparable corporate debt rated BBB.

The relatively high payout made CoCos a popular fixed income instrument in actively managed, yield-focused portfolios. Specifically, private banks in Asia have been big buyers of CoCos, buying up new issuances for their ultra-wealthy clients. As of February 2022, the AT1 CoCo’s market was in excess of $250 billion USD, according to the investment management company Invesco.

The recent banking crisis and the risks of CoCos

In mid-March 2023, following the collapse of Silicon Valley Bank and Signature Bank in the U.S., investors began to voice additional concerns about the liquidity and potential losses embedded in the securities held on the balance sheets of global banks. On March 14, PwC, the auditor of Credit Suisse, identified “material weaknesses” in the bank’s financial reporting. The next day, investors initiated a massive sell-off of Credit Suisse stock. On March 19, Credit Suisse and UBS entered into a merger agreement, with UBS being the surviving entity. On the same day, Credit Suisse was informed by the Swiss Financial Market Supervisory Authority (FINMA) that Credit Suisse’s AT1 Capital (deriving from the issuance of Tier 1 Capital Notes) in the aggregate nominal amount of approximately 16 billion Swiss francs would be written off to zero.

Contrary to market expectations, Credit Suisse’s shareholders were not wiped out completely. Typically, when a company goes out of business, bondholders rank above the common equity shareholders in the creditor order for any recoveries that can be paid. Under the terms of the Credit Suisse and UBS merger agreement, all equity shareholders of Credit Suisse will receive 1 share in UBS for 22.48 shares in Credit Suisse.

FINMA’s treatment of AT1 CoCos as more junior than common equity raised a level of “regulator risk” in Europe. Several other European issuers had to reassure investors that the common equity ranks lower than CoCos in the creditor priority, and that the move by the Swiss bank regulator was a necessary step to prevent a widespread banking crisis. The Credit Suisse AT1 CoCos write-down to zero was the biggest since these instruments were created. The only other example of CoCos default was in 2017, when EUR 1.35 billion of Banco Popular’s AT1 bonds were written down.

Risk/reward profile of AT1s

AT1 CoCos offer an attractive risk/return profile as well as diversification benefits due to their low correlations with traditional fixed income assets, as demonstrated by the correlation table.