What happened?

The Swiss authorities decided to use their power to write down Credit Suisse (CS) Additional Tier 1 (AT1) bonds (also known as contingent capital or CoCo bonds) in full, even though equity was not written down to zero as part of the deal where UBS acquired CS for CHF 3bn. While a resolution of CS was avoided, the Swiss government provided CHF 9bn second-loss guarantee to UBS (approved with a new law ) and therefore was allowed to write-down the AT1s. This is clearly an unfortunate event for CS AT1 investors.

 

CS started from a weak position. After a long period of poor performance, deposit outflows accelerated after the news of a lack of additional support from Saudi National Bank, the largest CS shareholder. Ironically, this was probably more driven by the size of their existing holding rather than a negative view of the bank.

 

The most surprising outcome was that the regulator allowed a full write down of CS AT1s while leaving residual value to equity holders. In order to persuade UBS to make the transaction the regulator not only guaranteed potential losses (CHF 9bn) on the valuation of the assets, but also permitted the AT1s write down. This appears to be legitimate: CS’s AT1 documents allow this action to be taken if the bank’s capital ratios fall below a certain point, which is common for AT1s across the globe. However, they also provide for a write-down if a point of non-viability is reached along with the need of “extraordinary support from the public sector”. CS found themselves in the second case.

 

So AT1 investors knew the risk: what’s shocked many market participants is that equity holders were paid CHF 0.76 a share in UBS shares despite having an explicitly weaker position in the capital structure. Does this set a precedent for AT1s? In our view it does not. While Swiss regulators have pursued an unusual course of action, other regulators were quick to distance themselves.

 

The European Central Bank (ECB) clarified immediately that common equity would be the first to absorb losses:

 

“Common equity instruments are the first ones to absorb losses, and only after their full use would Additional Tier One be required to be written down. This approach has been consistently applied in past cases and will continue to guide the actions of the SRB (Single Resolution Board) and ECB banking supervision in crisis interventions.”

 

The Bank of England (BoE) also confirmed that “AT1 instruments rank ahead of CET1 and behind T2 in the hierarchy.”

 

This is therefore an idiosyncratic event, in our view. CS was in a very weak position and at risk from deposit flight in an environment of rapidly tightening liquidity. Given public liquidity was used, their AT1s were wiped out. It’s rather unusual that equity holders received some small compensation, but it’s clear to us that this is not a course other regulators would follow.

Our positioning coming into these events
Our job in managing the Contingent Capital strategy is to identify the right exposures across financial issuers and the best place in the capital structure to own them. Given the fundamental problems that CS has had over a significant period and the volatility we saw in recent months, we saw significant execution risk for the bank as it tried to return to profitability. Therefore, we did not own CS AT1s.

At the same time, we had high conviction that CS is a systemically important bank which the Swiss authorities would stand behind, and so it has proved. We therefore owned CS senior debt, which has been protected throughout this process, and has delivered positive performance in particular after the news of the UBS takeover.

Looking at the rest of our exposure, over the past few months we identified that tighter liquidity and higher recession risk would put pressure on bank valuations. Against that challenging backdrop, we have had other bank CoCos exposure at the minimum permitted by our prospectus (a little over 75%), preferring higher seniorities and cash. This positioning has helped the strategy materially outperform its benchmark.
Could this create a new standard for AT1 as an asset class?
The only precedent before CS was Banco Popular, which underwent a full resolution procedure. In that case equity, AT1 and T2 were cut to zero and the bank was sold to Santander for 1 euro. This case is very different: CS has been acquired and its viability clause was triggered. In Europe, if any bank were to have stress or non-viability the normal playbook would be to write down equity before AT1, and regulators have emphasised this point. We therefore view this as idiosyncratic. The point of owning AT1s remains the same: access to higher yields in return for a weaker position in the capital structure, but still higher than equity. That’s an attractive proposition if you select the right issuer.
Should spreads on AT1s be wider?
There may be some consequences for the cost of capital for banks, and ongoing volatility.

We would expect the AT1 market to stabilise over time as perspective returns to the market. The asset side of CS was not fundamentally impaired. What we saw last week was a loss of confidence for a bank that was already in a challenging restructuring path, leading to deposit withdrawals which were exacerbated by miscommunication from a key shareholder.

Other European banks are in a much more robust situation, with better profitability profiles and lower levels of uninsured deposits.
AT1s of UBS in the Contingent Capital strategy?
The Contingent Capital strategy is also underweight UBS AT1s vs. the benchmark, with 1.4% of the strategy in the bank vs. 5% in the benchmark. Nevertheless, we are relatively comfortable with the deal that UBS got, given the low price and high level of government guarantees. These look to be good terms, in our view. After the experience of AT1 CS holders, we think the market is likely to be wary of AT1s issued by Swiss companies, which is why we are maintaining a large underweight positioning. It’s easier to have faith in European and UK regulators’ actions going forward.
Why invest in AT1s going forward?
CoCos or AT1s were designed after the 2007-2008 Global Financial Crisis as a way for banks and regulators to manage their debt more efficiently and ultimately help resolve future crises more easily. As an investor, what you receive is a higher yield (now in excess of 15% in some cases) in return for a weaker position in the capital structure. It’s important that the position in the capital structure is protected, which is why the statements made by the ECB and the BoE immediately after the merger was announced were so important: AT1s remain an important component of bank capital and rank ahead of equity.

As well as a higher yield, the multiple layers within banking capital structures allow active managers like us the ability to implement our fundamental analysis of banks. We can take AT1 risk in healthy banks and take no risk or only senior risk in weaker institutions.

Even after the CS debacle, the European banking system looks very healthy, in our view. Capitalisation ratios are 2-3x higher than in 2007. The banks are stress-tested regularly on a capital and liquidity perspective. Given that reality, the yields available on AT1s relative to the risk involved are extremely attractive — even more so after recent events. As always in fixed income, you need to avoid the bad apples through rigorous selection as the case of CS clearly demonstrates.

The value of active minds: independent thinking

 

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