Anniversary of the Credit Suisse/Ubs integration: the CoCos circle closes

AUTHOR: Pierre Verlé, Head of Credit, Carmignac

To understand the relevance of the Credit Suisse case, we must bear in mind the reason why Additional Tier1 contingent convertible bonds were originally conceived. In the wake of the great financial crisis, contingent convertible bonds (CoCos) were devised by regulatory authorities to help banks meet stricter capital requirements. In case of crisis, they can be cancelled (or converted into shares). The advantage for holders is a significantly higher return, while for the banking system it is the recapitalization of a fragile institution, the facilitation of an extraordinary finance solution (such as an acquisition) and the possibility of avoiding a systemic crisis.

After a series of errors, Credit Suisse, a bank of systemic importance, lost credibility in the financial markets following the failure of three American banks. Given the nature of the crisis, its CoCos quickly came under fire. In the days leading up to the acquisition announcement, the bank found itself surrounded by rumors of a liquidity crisis. The devaluation of 16 billion Swiss francs of Credit Suisse's entire AT1 package undoubtedly contributed to UBS's decision to take the big step. The challenge, however, was not so much the devaluation of the AT1 CoCos, but the payment (in the form of UBS shares) to Credit Suisse shareholders, contravening the principle of seniority of repayments in case of crisis. The dispute continues and the slight rebound in the price of Credit Suisse's AT1 credits (which are now traded at a level above 10% of their nominal value compared to less than 2% recorded immediately after the announcement) suggests that some distressed investors see the concrete possibility of an agreement.

Investors observing the situation wondered: if financial institutions can disregard their own repayment system, placing shareholders above junior CoCo holders, does it make sense to invest in these instruments rather than in shares – their “cousins” (presumably) with a higher return?

In light of this phenomenon, the AT1s have taken a hard hit. On March 20, the yield of the CoCo index briefly exceeded 10%, the highest level since its creation in 2013, as well as almost 3% more than three years earlier, at the height of the Covid crisis.

However, in this panic situation, the crux of the matter was not grasped. Not only were various elements related to the acquisition of Credit Suisse peculiar, including the role and timing of the main shareholder and the Swiss regulatory framework, but above all, in perspective, the CoCos played their role: facilitating a convincing restructuring of a bank that had lost its most important asset, the trust of its shareholders.

A crisis was managed to be avoided despite the suffering of a systemically important bank, and the medium-term contagion to other financial institutions was contained. Convertible bonds acted as a "switch", so the cost of fleeing the bank was essentially limited to Credit Suisse's AT1 holders (and, in part, to shareholders). Undoubtedly the social cost of Credit Suisse's collapse was significantly lower than the average of banking crises.

Today CoCos are traded at about the same level, in terms of spread, as February 2023. Credibility has been restored. And once again, investors price the risks of a bond based on individual financial institutions, rather than on a generic systemic risk.

CoCos continue to play a significant role in containing potential crises, as they help to strengthen a bank's capital. Moreover, the individual assessment of a credit opportunity is exactly the method by which a healthy market should be managed. CoCos have definitely come back into the spotlight among investors. And, provided that a solid analysis of the fundamentals of the individual title is carried out, these instruments represent an interesting way to access those banks that have committed themselves deeply to improving their financial stability after the great crisis of 2007-08