Implications of Credit Suisse Takeover by UBS for Bond Investors

In the commentary below, Loomis Sayles Credit Research shares insight on the takeover of Credit Suisse by UBS, what AT1 bonds are, and how global banks and bond investors may be impacted.

Despite weaker overall market sentiment immediately following the bank takeover announcement, we believe this deal was likely the best outcome for the stability of global markets. While risk of direct fundamental contagion to other global banks is limited in our view, we expect market sentiment to remain fragile nearer term.

The details

• With significant financial assistance from the Swiss government, UBS agreed on March 19 to acquire Credit Suisse for 3 billion Swiss francs in an all-stock deal. In the process, the Swiss government determined that Credit Suisse had reached the "point of non-viability," which triggered a full writedown of the group's deeply subordinated additional tier 1 (AT1)¹ bonds.
• In our view, the UBS–Credit Suisse deal should help prevent contagion and will have little direct fundamental impact on other global banks. Global banks have exposure to each other through covered bonds (very senior debt backed by mortgages and held for liquidity purposes) and as counterparties, but these should not be affected because of this acquisition in our view.
• Though we think contagion risk is limited, we expect market volatility to persist for global banks. This should generally put upward pressure on bank funding costs, both wholesale funding and retail deposits, which may lead to tighter lending standards that exacerbate already weakening economic projections.
• Near term, we anticipate greater dispersion between stronger issuers and weaker issuers, and between more senior and more subordinated debt in the capital structure. Banks still need to address their regular funding needs and will have to return to the new issue market at some point; issuing into weakness could weigh on spreads.

AT1s, T2s, Senior Holdco Bonds: Not All Subordinated Debt Is Created Equal
The writedown of Credit Suisse’s additional tier 1 (AT1) bondholders appeared to undermine confidence in debt issued at lower levels of the capital structure, particularly because equity holders, who are typically supposed to rank at the bottom of payment priority, recovered some value in the forced sale. However, there are important distinctions between AT1 bonds due to local regulations, and among AT1 bonds, tier 2 (T2) bonds, and senior holding company (holdco) bonds.

Loomis Sayles did not own Credit Suisse AT1 bonds. We evaluate individual AT1 bond issues from a bottom-up fundamental perspective and also consider the regulatory framework in the issuing bank’s country of domicile.

The details

• We believe the Credit Suisse AT1 writedown illuminated two key takeaways for investors. First, losses at this level of the capital structure are possible even for a global systematically important financial institution. Second, the AT1 level of subordinated debt is highly susceptible to decisions made by local regulators, who often have a number of different stakeholders in mind.
• Importantly, the structure of Swiss AT1s is different from that of AT1 bonds issued by the United Kingdom and eurozone banks. UK and eurozone AT1 bonds typically stipulate that they will be converted to equity or temporarily written down. By contrast and per local regulatory framework, the Swiss regulator was obligated to permanently write down the AT1 debt in full. Conversion and temporary writedown options would avoid treating equity holders as senior to AT1 holders, a detail of the Credit Suisse deal that created substantial backlash. However, these measures would not reduce the likelihood of the AT1 bonds being bailed in (the process through which private creditors take losses). The Bank of England and European Banking Authority emphasized these differences, which appears to have reassured investors and helped calm markets for now.
• AT1 bonds are callable instruments. At this time, almost all calls are likely uneconomical due to the steep price declines the market experienced after the deal announcement. Though much of the market has rebounded, we expect continued choppiness. Technical factors could also play a role, as funds dedicated to investing in subordinated debt may need to sell securities in order to meet redemptions.
• Markets penalized T2 bonds along with AT1s, but in our view there is an important difference between deeply subordinated AT1 bonds and more traditional subordinated T2 bonds. AT1 bonds are considered "going concern capital," meaning they are specifically designed to absorb losses during times of distress so that a bank can recapitalize itself and continue operations. T2 bonds, though still subordinated debt, are considered "gone concern capital." This means they are only bailed in once AT1s have been exhausted and there are no options other than more extensive government intervention and potential breakup of the bank. T2 bonds, based on the regulatory framework, cannot as easily be bailed in.
• Senior holdco bonds operate similarly to T2 subordinated debt, but they are more senior in the capital structure and cannot be bailed in until T2 bondholders have been fully wiped out. (In countries where banks can operate without a holding company, senior non-preferred bonds were created to function similarly to holdco bonds.)
• In a liquidity event, as was the case for Credit Suisse, T2 and senior holdco bonds are less likely to be affected. However, if a bank experiences more severe capital shortages, they are more likely to be bailed in. In our view, spillover volatility in the T2 and senior holdco bond markets may not be warranted short term, but this debt could underperform longer term if banking system stress leads to economic recession.

This analysis was written on March 22 by the Credit Research Team at Loomis, Sayles & Company.