Navigating the Resurgence: A Recap of the CoCo Market’s Journey Post-Credit Suisse Crisis

On March 19th, 2023, FINMA made the decision to devalue Credit Suisse AT1 instruments by CHF 16 billion as part of the bank's rescue plan led by UBS. This move sent shockwaves through the CoCo market, causing a sudden drop of around 7% in volume compared to the beginning of the year and a 13% decline relative to the US$ CoCo market. The ripple effect extended to the broader AT1 market, resulting in a -14.3% downturn in the ICE BofA CoCo index by market close on March 20th, following a record high of +6% on February 3rd, 2023.

Fast forward to 2024, the index experienced a significant rebound, closing at +5.7% by the end of the year. By March 11th, the index had surged +26.4% from its lowest point in March 2023. Despite tightening in other bond segments, the CoCo segment remained appealing, primarily due to its attractive yield of 7.06% and, to a lesser extent, its credit margin (371 basis points).

Shortly after the Credit Suisse crisis, European and British regulatory authorities reaffirmed the importance of AT1s in bank capital structures, emphasizing equal treatment between shareholders and bondholders, even junior ones. These statements contributed to the asset class's recovery.

The primary market quickly regained momentum, with cumulative issuances reaching 30 billion euros equivalent in 2023. Euro issuances began in June 2023, followed by dollar market issuances from August 2023, including UBS's highly anticipated issuance in November 2023, which attracted record combined orders of around $30 billion.

The strength of the primary market played a significant role in the segment's improved performance. Most European banks achieved their targeted AT1 issuance volumes, facilitating the calling of existing instruments. This trend continued into 2024, with the majority of calls expected to occur within the AT1 segment, potentially enhancing performance for investors.

A broader base of investors, including dedicated CoCo funds, diversified asset managers, and private banks, returned to the market, supported by European demand and renewed risk appetite from Asia and the United States.

However, uncertainties linger regarding the mid-term regulatory impact. Some members of the Basel committee criticized AT1s' ability to absorb losses effectively, while market players advocated for stricter rules on call conditions. Despite these discussions, the status quo prevails for now.

Swiss AT1 issuers felt the impact, particularly UBS, whose recent issuances introduced a structural change by allowing conversion into equities following approval in April 2024. This normalized the cost of issuing CoCos for UBS, complicating the estimation of a residual "Swiss" risk premium due to unique cases like Julius Bear's exposure to the Signa group.

The market's normalization primarily stems from banks' robust solvency and liquidity levels, bolstered by higher interest rates and sustained profitability, as evidenced by Q4 2023 earnings reports. Despite concerns about specific exposures, such as commercial real estate, and the specter of past crises, market psychology remains cautious, anticipating potential future challenges.

In summary, while the market has seemingly absorbed recent shocks, vigilance remains high, recognizing the potential for future bouts of volatility and uncertainty.