Buildings of Swiss banks UBS and Credit Suisse are seen on the Paradeplatz in Zurich, Switzerland.
| Photo Credit: DENIS BALIBOUSE
European bank bonds slumped on Monday following the state-backed rescue of Credit Suisse by UBS as a wipeout of some bondholders raised concerns around broader bank capital and also hammered bank shares.
The Swiss authorities’ handling of the Credit Suisse rescue has upended the understanding in the bond market that shareholders would take a bigger hit than bond investors in such a scenario.
Under the rescue deal, 16 billion Swiss francs worth of Credit Suisse’s bonds, known as Additional Tier 1 (AT1) debt or CoCos (contingent convertibles) , will be written down to zero on the orders of the Swiss regulator as part of the merger with UBS, a decision that surprised bondholders.
AT1 bonds – a $275 billion sector also known as “contingent convertibles” or “CoCo” bonds – can be converted into equity or written off if a bank’s capital level falls below a certain threshold.
The write-down to zero at Credit Suisse will produce the largest loss in the $275 billion AT1 market to date, dwarfing the 1.35 billion euros ($1.44 billion) bondholders of Spain’s Banco Popular lost in 2017.
“The takeover of Credit Suisse by UBS was done fast and should have provided reassurance to the market that we haven’t had another bank collapse. However, what it has done is exposed the issues around AT1 bonds,” said Russ Mould, investment director at AJ Bell.
AT1 bonds are a form of deeply subordinated debt that converts into equity or is written off if a bank’s capital levels fall below a certain threshold, depending on the terms of each individual instrument.
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Credit default swaps of European lenders – instruments used to insure against exposure to default risks – widened sharply across the banking sector.
In the bond market, Credit Suisse’s Additional Tier 1 (AT1) bonds were bid as low as 1 cent on the dollar on Monday as investors braced for the wipeout.
AT1 bonds in other banks tumbled as Credit Suisse’s wipeout raised concerns about investing in such debt issued by other banks.
European supervisors tried to stop a rout in the market for convertible bank bonds on Monday, saying owners of this type of debt would only suffer losses after shareholders had been wiped out.
Bid prices on AT1 bonds from banks including Deutsche Bank , HSBC, UBS and BNP Paribas dropped 9-12 points on Monday, sending yields sharply higher, data from Tradeweb showed.
A UBS AT1 bond that is callable in January 2024 was trading at a yield of nearly 29%, up from 12% on Friday, demonstrating how much more costly such debt could become.
“The specific CS situation is mostly bedded down now, but it’s no time for complacency,” said Wolfgang Felix, senior analyst at credit firm Sarria Limited. “CoCos are down across the board this morning as investors realise that these bonds contractually circumvent the concept of absolute priority to their own disadvantage,” .
“So the mob is angry and scared and is looking for the next best target. The focus is moving to other issuers of CoCos, which includes most of Europe’s larger banks. It’s not a good situation.”
Funds that track AT1 debt also fell sharply.
Invesco’s AT1 Capital Bond exchange-traded fund, was last down 9%, while WisdomnTree’s AT1 CoCo bond ETF was indicated 7% lower.
Shares in Credit Suisse fell as much as 64.5% while UBS Group shares dropped as much as 16%.
Bank stocks then recovered some losses throughout the morning and by 1106 GMT were down 1.4%.
The European banking index has shed around 18% this month after the recent failure of several regional U.S. banks starting with Silicon Valley Bank prompted a wider sell-off in bank shares.
The uncertain situation was also reflected in the rising cost of insuring exposure to the debt of other banks in the credit default swaps (CDS) market.
UBS CDS widened 63 basis points to 180 bps – levels last seen more than a decade ago. Among the other lenders, Deutsche Bank and UniCredit saw some of the sharpest increases at 20 bps and 13 bps respectively, S&P Global Market Intelligence data showed.