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Move on, there's nothing wrong with the AT1 market

everything is fine and beautiful

As European regulators give their full and explicit support, the market is serving the purpose it was created for

What investors did following the write down of Credit Suisse’s Sfr16bn-equivalent of additional tier one (AT1) bonds to zero was a nothing short of a full-scale rebellion. But, despite the calamity, there is no need to panic. The AT1 bond market is just fine.

In fact, the debt capital instruments served their intended purpose in Credit Suisse’s resolution and despite the ongoing turmoil, the asset class remains a viable capital option for other European banks.

As GlobapCapital reported, events on early Monday morning were total carnage across the board. AT1 bonds were marked down by banks in all jurisdictions, with some European AT1 notes dropping by as much as 25 points within half a trading day. The devaluation spread like forest fire to the rest of the unsecured bank debt, pushing out even senior bond spreads to their widest levels since Covid-19.

But the repricing of the market was not because investors in the asset class were completely wiped out. In fact, they really should have seen it coming.

These instruments were, and even more so now are, high yielding subordinated bonds: a bank capital layer designed after the global financial crisis of 2008 to involve investors in bank bail-ins rather than have governments, and therefore the public, bear all the bail-out costs.

The biggest problem for investors in Credit Suisse's AT1 bonds was that equity holders received Sfr3bn of return in the form of UBS shares. Investors were perplexed that the rules of the game had been changed in the dying seconds to suit the Swiss government. Within most of the bond market, the assumption has always been that equity investors sit at the bottom of the capital structure pile.

One investor also pointed out that the bank was rubbing salt on their wounds with its stringent commitment to pay banker bonuses, even though these individuals arguably sat lower down in the capital hierarchy than the creditors that provided the AT1 capital.

Because of that, or perhaps more generally because of the sensitive political nature of banker bonuses, by late Tuesday the Swiss government was said to be clamping down some of CS’s promised bonuses.

The correct hierarchy may be far from clear though the arguments from investors are valid, irrespective of whether they are direct holders of CS’s specific AT1 bonds, or are more broadly involved in the AT1 market as a whole.

The biggest supporters of AT1 investors have been European (not Swiss) bank regulators and supervisors. As well as the Bank of England, the Single Resolution Board, the European Banking Authority and the European Central Bank have all voiced support for the capital hierarchy that states AT1 should sit above common equity tier one in case of a bank resolution.

In fact, statements from the eurozone and UK regulators are the best support the AT1 market can hope for.

This backing should also mean that the Swiss case — the first major and systematically important bank failure after the global financial crisis — remains an isolated event. Not only do the regulators provide weight for the asset class — not least to stop the ballooning cost of funding for other European banks — they also clearly distance themselves from the Swiss Financial Market Supervisory Authority and its decision in the CS resolution.

The AT1 market, estimated at just over $260bn-equivalent following the write-down of the CS bonds, is now mostly a mature market compared to the immediate years after the GFC when banks were still required to shore up their bail-inable capital. Almost all major banks have built or are close to their optimal levels of AT1 capital.

Moreover, the assumption that a bank calling its AT1 debt means an immediate or a near-term refinancing may also not hold. Profits have risen with higher net interest margins, while funding costs have also spiked, especially for the riskiest subordinated debt following the demise of CS. That could tempt a bank to fill its AT1 capital needs through other means, such as retained earnings.

But most importantly, AT1 instruments largely served their intended purpose in the case of CS's resolution. The fast-deteriorating conditions of the troubled Swiss bank meant that state support was needed. This was provided through emergency liquidity lines and ultimately through the loss back stops the Swiss government is providing UBS for the takeover.

These were clearly extraordinary circumstances and the AT1 capital, as had been indicated in documentations from the onset, was written off.

If banks are indeed well-capitalised with abundant liquidity — and European banks largely are — and not besieged by scandals and litigation after litigation as Credit Suisse was, they should have nothing to worry about. The AT1 asset class pays equity-like returns due to its contingent, crisis capital.

But if there is no crisis of confidence, then all is fine and AT1 debt capital has worked as it was intended.