Subordinated bank bonds are once again in the spotlight after Zürcher Kantonalbank skipped a call option. The decision led to price losses in the Swiss franc denominated AT1 segment.
Last Thursday (31 August 2023), in Swiss francs denominated subordinated AT1 bank bonds, known as contingent convertible bonds or CoCo bonds, again came under massive pressure.
Subordinated bonds issued by Swiss financial institutions were once again in the spotlight, just as they were in March this year, when this category of bonds gained inglorious fame in the wake of the state-orchestrated integration of Credit Suisse into UBS. This followed the decision by the Zürcher Kantonalbank (ZKB) to forgo a call option on one of these bonds.
A brief explanation: AT1 bonds are a form of capital provided by banks that can be converted into equity in case of bankruptcy or a crisis of confidence, but can also be written off on a temporary or permanent basis. This capital instrument was introduced after the 2008 financial crisis to increase the stability of the banking system.
In addition to a contractually agreed interest rate adjustment in case of a non-call event, ZKB's surprising decision led to a significant fall in the price of the bond in question. Similarly structured securities of other issuers also suffered price losses. It is important to note that, unlike the less subordinated Tier 2 bonds, AT1 bonds do not have a step-up clause, ie an automatic increase in the credit risk premium in the event of a skipped call event. The interest payable is generally only adjusted to the current interest rate level.
This shows once again that the risks in the AT1 segment are not limited to the solvency of banks but are also highly dependent on trust and reliability. While the waiving of early repayment is not a disaster, it has fueled suspicions that banks may not be willing or able to accept higher costs. If opportunistic behaviour by an issuer becomes the norm, it is likely that investors will demand higher risk compensation for new issues in the future. Conversely, this would also mean that the credit risk premium on the bonds currently outstanding is too low.
In our view, it is an open question whether the AT1 structures designed for the Swiss market will survive in their current form in the long-term. This is due to the overall increase in financing costs. This makes the instrument less attractive from a company's point of view compared to paid-in share capital. Moreover, the question arises as to whether AT1 bonds are fundamentally suitable for stabilisation in crisis situations or whether they are more likely to act as a catalyst.
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