What are AT-1 bonds and why are they relevant for investors?
Additional Tier 1 bonds (known as AT-1 bonds) are a type of hybrid capital instrument that combines features of debt and equity. They were created to provide banks with an additional layer of loss-absorbing capital that can be used to absorb losses in times of financial distress. They first came to prominence in 2010, however, in the wake of the forced takeover of Credit Suisse by banking rival UBS, AT-1 bonds have hit the headlines again.
The write-down of the AT-1 bonds as part of the Credit Suisse list of creditors whilst equity shareholders received a payout was controversial, even if it proved to be within the rules. As a banking crisis has threatened to grab financial markets by the scruff of the neck once more, we look more into what AT-1 bonds are and their relevance for investors.
What are AT-1 bonds?
AT-1 bonds are a type of hybrid debt instrument issued by banks and other financial institutions to raise capital. These bonds are structured to provide a perpetual source of funding for the issuer, with no fixed maturity date. Instead, the issuer has the option to redeem the bonds at certain intervals or under certain conditions.
The bonds are classified as Tier 1 capital under the Basel III regulatory framework, which sets minimum capital requirements for banks and other financial institutions. This means that AT-1 bonds can be used by banks to meet their regulatory capital requirements.
What makes them unique is their “loss-absorbing” feature. They provide a buffer of capital that can absorb losses in case the financial institution experiences financial distress. This means that if the issuer’s capital levels fall below a certain threshold, the bonds are structured to convert into equity or can be written down. This helps protect investors from losses in the event of the issuer’s financial distress, while also providing an incentive for the issuer to maintain strong capital levels.
High-risk but high-yield investment
As they are subject to complex terms and conditions, AT-1 bonds are also considered to be a high-risk investment. Their value can therefore be highly volatile. Subsequently, they are generally only suitable for sophisticated investors who understand the risks involved.
AT-1 bonds offer higher yields than traditional debt instruments due to their increased risk profile and the possibility of conversion or write-off. They are typically sold to institutional investors, such as pension funds, insurance companies, and hedge funds, who are willing to take on higher risk for the potential for higher returns.
AT-1 bonds are subject to strict regulatory requirements, and their issuance and conversion must comply with specific rules and guidelines established by regulatory bodies such as the Basel Committee on Banking Supervision.
The history of AT-1 bonds
AT-1 bonds were introduced as part of the Basel III framework, which was developed by the Basel Committee on Banking Supervision in response to the global financial crisis of 2008. The Basel III framework aimed to strengthen the resilience of the banking sector by increasing the quality and quantity of regulatory capital that banks are required to hold.
The first AT-1 bond was issued in 2013 by Credit Suisse, followed by several other banks, including UBS, Barclays, and Deutsche Bank. The market for AT-1 bonds grew rapidly, and by 2018, over $200 billion worth of AT-1 bonds had been issued by banks around the world.
A controversial capital instrument
The complexity of AT-1 bonds and the risks associated with them has led to concerns among regulators and investors. In particular, there were concerns that investors did not fully understand the risks associated with AT-1 bonds and that the bonds could be used to circumvent regulatory requirements.
As a result, regulators introduced new rules in 2017 to clarify the terms and conditions of AT-1 bonds and ensure that investors are fully informed about the risks involved. These rules included requirements for issuers to provide detailed information about the triggers for conversion or write-off of the bonds and restrictions on the circumstances under which the bonds can be redeemed or repurchased.
Despite these concerns, AT-1 bonds continue to be an important tool for banks to raise capital and meet regulatory requirements.
The hierarchy of creditors
The hierarchy of creditors refers to the order in which different types of creditors are repaid in case of a default or bankruptcy by a debtor. The following is a general hierarchy of creditors:
- Secured creditors: Secured creditors are those who have a legal claim on specific assets or property of the debtor that they can seize and sell in case of a default. They have the highest priority and are paid first from the proceeds of the sale of the assets they hold a security interest in.
- Unsecured creditors: Unsecured creditors do not have any specific security interest in the debtor’s assets and are therefore paid after the secured creditors. They may include suppliers, vendors, or service providers who have provided goods or services on credit, or lenders who have extended unsecured loans.
- Subordinated creditors: Subordinated creditors have lower priority than secured and unsecured creditors and are repaid after them. They are typically lenders who have agreed to subordinate their claims to those of other creditors in exchange for a higher interest rate or other benefits.
- Equity holders: Equity holders are the last in the hierarchy and are only paid after all other creditors have been paid in full. They are the owners of the company and hold shares in the company’s stock. In case of liquidation, they may receive a residual claim on the assets of the company, if any is left after paying all the other creditors.
Additional Tier-1 bonds sometimes referred to as a “contingent convertible” (or CoCos for short) come under the category of “Subordinated creditors”.
However, it is important to note that this is a general hierarchy, and the specific order of payment may vary depending on the laws and regulations of the jurisdiction in which the debtor is located, as well as the specific terms of the creditor agreements.
Controversy and the role of AT-1 bonds in the UBS takeover of Credit Suisse
UBS agreed to a takeover of Credit Suisse over the weekend on the 18th/19th March for a deal worth around $3.15bn. This was significantly lower than the closing value on 17th March of around $8bn. However, this was not the only controversial aspect of the takeover.
The devil was all in the detail. Aside from shareholders of both banks not getting a vote in the deal, it also involved AT-1 bonds being written down to zero. The AT-1 bonds of Credit Suisse were valued at 16 billion Swiss francs (c. $17bn).
Normally, according to Basel III and the Bank of International Settlements, shareholders get wiped out first, but not this time. Equity holders received compensation, whilst the AT-1 bondholders got nothing. The Credit Suisse situation raises some key issues.
Reportedly, the Credit Suisse AT1 prospectus does suggest that shareholders are prioritised over the AT-1 bondholders, but specifically in the event of the bank “failing”. This is the key issue. Did the takeover of Credit Suisse constitute the bank “failing”?
Potential legal recourse will be watched with interest
In 2017, there was a banking failure that resulted in the AT-1 bonds being wiped out. Banco Popular collapsed, but this also came with shareholders losing everything too. Despite this, there were legal challenges to the collapse. As we write, there are reported moves towards potential legal proceedings by the AT-1 bondholders of Credit Suisse.
With FINMA (the Swiss Financial Market Supervisory Authority) justifying the move, European regulators are saying that this is a one-off. However, it does mean that it is now a big test for AT-1 bonds. It has the potential to significantly damage confidence in the asset class.
According to Lazard’s data, up to the end of September 2020, around 100 financial institutions were having issued AT-1 bonds. Estimates suggest that of the cumulative issuance of $900bn, around $260bn remains outstanding in the market.
Subsequently, the writedown of $17bn AT-1 bonds of Credit Suisse represents around 6% of the whole market. The prospects of the remaining AT-1 bond in banks around the world will be hanging on potential legal proceedings. Bondholders will be watching the developments with interest.
