The recent events surrounding Credit Suisse (CS) have illustrated that Additional Tier 1 (AT1s) or also known as CoCo’s/Contingent Capital are inherently risky investments which can result in a 100% loss of investor capital. While the outright 10% yield to call (YTC) can be alluring, this is a good example of circumstances where AT1s can behave like equity investments when things go wrong, leaving investors with nothing. In fact, in this case AT1 investors received less than equity investors!
IAM always ensures professional investors buy into our financial new issues to ensure the risk has been appropriately analysed. Furthermore, our IAM balanced model portfolio contains Investment-Grade (IG) rated securities only and is diversified across banks and corporates, with a focus on Tier 2 (T2) securities. We want the overall portfolio yield to provide a good income return for investors while avoiding capital volatility as far as possible, therefore mitigating the risk of one position (i.e., a CS security) negatively impacting or even negating the whole return (and more) in one hit, leaving investors disappointed.
It has been confirmed that UBS will acquire Credit Suisse in a momentous deal which will change the banking landscape going forward. UBS will be the surviving entity upon closing of the merger transaction. Last week everyone became an expert on the US regional banks we’ve never heard of, starting with “S” – including Silicon Valley Bank, Silvergate and Signature Bank. Now, the widely known CS has been thrown into the mix, even though there wasn’t any material new information to suggest any further weakness in CS’s fundamentals. A classic case of the market being on edge.
The transaction will be brokered by the Swiss National Bank (SNB) and Swiss Financial Market Supervisory Authority (FINMA). It will see CS shareholders receive 1 UBS share for every 22.48 CS shares held, equivalent to CHF0.76/share for a total consideration of CHF3bn (CS closed at CHF1.86/share on Friday). There will be extraordinary government support from the Swiss Government and therefore will trigger a complete write down of the nominal value of all Additional Tier 1 of CS (c.CHF16bn) to zero. For clarity, these carry Permanent Writedown features to zero. This will increase core capital, essentially providing UBS with capital to manage potential losses from restructuring and winding down assets. The merger will result in a larger bank, for which the current regulations require higher capital buffers not yet defined. FINMA will grant appropriate transitional periods for these to be built up. The emergency measures extend to a 100bn liquidity facility as well as CHF9bn second-loss guarantee from the Swiss Government (CHF5bn first-loss to UBS).
Importantly, there was no reference to CS’ Tier 2 securities in the FINMA statement. The CS Group (holdco) and CS Operating Company (opco) senior bonds remain obligations of CS Group and CS Operating Company as fully owned subsidiaries of UBS. UBS has confirmed its day-1 proforma CET1 will be ‘significantly above’ their 13% target. This is a good outcome for broader stability of the banking sector and CS T2 and senior bonds.
In our view, Australian banks should outperform offshore banks here. The major advantage in the T2 and AT1 market for Australia banks is that they must be converted to equity as the default option (as opposed to being written down in offshore markets). In terms of AT1 – we would differentiate between AT1 institutional-led deals and AT1 retail led/hybrid deals. We expect AT1 institutional-led deals to be better supported as holders are buy and hold investors with longer term horizons in securities that are better priced for the risk. The AT1 retail led/hybrid deals have attracted investors who have been more price agnostic and just bought AT1 investments through primary as an alternative to bank equity. On this basis, negative market sentiment will likely see selling in these AT1 retail led/hybrid deals and they could trade weaker as a result. Crucially, neither CS’ T2 nor senior bonds wore any losses. Debt was safeguarded – and for this reason we have high conviction over T2 securities issued from Australian banks. T2 is also looking cheap on an AT1 / T2 spread and on a T2/senior unsecured basis.
Can a similar case be drawn for Australian banks as was the case with CS? I would think not. Australian ADIs’ loan books are skewed towards residential mortgages and operate under tighter regulations with little investment banking activities (as was the CS focus). Furthermore, most Australian ADIs are required to account for interest rate risk in the banking book (IRRBB) in accordance with APRA Prudential Standard APS 117. In addition, APRA can impose separate measures if at any time APRA feels a non-significant financial institution’s (Non-SFI) balance sheet and operations aren’t appropriately measuring interest rate risk. CS’s fallout will inevitably contribute to negative market sentiment but Australian banks are still in tip-top shape.
