AT1 Bonds

By: eli levy  |  April 21, 2023

By Eli Levi

Recently, Credit Suisse was rescued by its longtime rival UBS. As part of the deal, the Swiss regulator wrote down the value of the bank’s so-called AT1 bonds to zero. This decision to write down 16 billion Swiss francs ($17.5 billion) of Credit Suisse bonds, known as Additional Tier 1 or AT1 debt, has thrown financial markets a fresh curveball.

AT1 bonds, short for Additional Tier 1 bonds, are a type of bank bond that is considered a relatively risky form of junior debt. They often come with a higher yield and are often bought by institutional investors. Sometimes they are also referred to as contingent convertibles or “CoCos” because of their ability to convert into either equity or be written off (cut their value to zero) in specific scenarios. This is often related to the capital ratio of the bank that issued the bonds. If it declines below a certain level, for example, the contingency plan of investors converting their holdings becomes an option.

AT1 bonds were created in the aftermath of the 2008 financial crisis when regulators tried to shift risk away from taxpayers and increase the capital financial institutions held to protect them against future crises. At the time, regulators in Europe established frameworks that specify capital ratios, so the balance between assets such as equity investments, AT1s, and other, more senior debt. This is also the order they are meant to be prioritized, according to the framework.

AT1 bonds offer higher yields than many comparable assets, in some cases yielding almost 10%, reflecting the inherent risk investors are taking. This higher yield is an incentive for investors to hold AT1 bonds despite their relatively risky nature.

In the case of Credit Suisse, the investments of AT1 bondholders were written off while common shareholders are set to receive a payout from the deal. This decision upended the usual European hierarchy of restitution in the event of a bank failure under the post-financial crisis Basel III framework, which ordinarily places AT1 bondholders above stock investors. This move was unusual and prompted investors to threaten legal action and other financial authorities across Europe to distance themselves from the Swiss Financial Market Supervisory Authority (FINMA). So in this particular case, it could be argued that AT1 bonds did not accomplish their original goal of shifting risk away from taxpayers and bolstering banks.

On the flip side, one could argue that the AT1 bonds did serve their purpose in the case of Credit Suisse. The AT1 instruments issued by Credit Suisse contractually provide that they will be completely written down in a ‘viability event,’ in particular if extraordinary government support is granted. As Credit Suisse received extraordinary liquidity assistance loans secured by a federal default guarantee on 19 March 2023, these contractual conditions were met for the AT1 instruments issued by the bank. So from this perspective, the AT1 bonds did serve their purpose of absorbing losses and protecting more senior creditors and taxpayers from bearing the cost of a bank failure.

Matt Levine argued something very similar in his “Money Stuff” newsletter stating, “[AT1 bonds] are, basically, a trick. To investors, they seem like bonds: They pay interest, get paid back in five years, feel pretty safe. To regulators, they seem like equity: If the bank runs into trouble, it can raise capital by zeroing the AT1s. If investors think they are bonds and regulators think they are equity, somebody is wrong. The investors are wrong.”

Levine is making the point that the very purpose of AT1 bonds is to be used in a liquidity crisis or really any crisis and is used to provide liquidity, unlike regular debt. 

This ties back to the original purpose of AT1 bonds and why they were created in 2008. The point was to incentivize the shareholders of these bonds to be more risk averse as they would be zeroed out in any bank run or crisis, exactly like what happened with Credit-Suisse.