The Swiss authorities’ decision to cancel Credit Suisse’s Additional Tier 1 (AT1) bonds may diminish demand for this form of bond in the long run, according to a Goldman Sachs strategist, but the danger of contagion across credit markets is limited due to the asset class’s relative niche character.
The Swiss regulator has ordered that $17 billion worth of AT1 Credit Suisse notes be written down to zero as part of a rescue merger with UBS (UBSG.S). Credit Suisse AT1 bond holders will earn nothing under the agreement, but stockholders, who commonly rank lower than bondholders in terms of who gets paid when a firm or bank fails, would receive $3.23 billion.
Other European banks that issued AT1 bonds dropped substantially on Monday as the treatment of Credit Suisse AT1 investors exposed the hazards of investing in this sort of bond.
According to Reuters, Lotfi Karoui, chief credit strategist at Goldman Sachs, said that the sell-off was a “knee-jerk reaction to an outcome that took a lot of people by surprise.”
But he added: “In the long term, we are a little concerned about the potential permanent destruction in demand… I do think that investors will have to re-assess how the risk-reward looks like in those instruments, particularly at times of rising financial distress.”
If a bank’s capital levels drop below a specific threshold, AT1 bonds operate as shock absorbers. They could be written off or turned into equity.
On Monday, European regulators attempted to avert the AT1 market rout by stating that owners of this sort of debt would only incur losses once shareholders were wiped out, in contrast to what unfolded at Credit Suisse. Meanwhile, law firm Quinn Emanuel Urquhart & Sullivan said it was speaking to various Credit Suisse AT1 holders about potential legal action.
Because of the size of the AT1 market and its investors, Karoui believes the possibility that a re-assessment of the chances of this type of instrument might impact the performance of the larger credit market remains modest.
He added AT1 bonds, with the exception of those issued by Credit Suisse, which added up to $100 billion in the dollar market and a little more than 70 billion in the euro market, in comparison to over $10 trillion of investment-grade bonds between the U.S. and Europe.
“I would view it as a small, niche asset class… I don’t think there’s overlap between the two investor bases,” he said.