Why Credit Suisse’s “Coco” bonds are causing anxiety

MUCH of the financial world has been watching Credit Suisse closely as it flirted with disaster, but few have done so with more worry than the holders of its contingent convertible bonds, also known as CoCos.

Sometimes described as high-yield investments with a hand grenade attached, CoCos are the lowest rung of bank debt. That means that while they produce juicy returns in good times, they are designed to be among the first to feel pain if a bank’s troubles get bad enough. 

Credit Suisse got a US$54 billion vote of confidence from the Swiss National Bank, but the value of its CoCos tumbled, leaving holders nursing some serious losses along with serious apprehensions.

1. What is a CoCo bond?

Introduced after the global financial crisis, they are essentially a cross between a bond and a stock that helps banks bolster capital to meet regulations designed to prevent failure.

They are contingent in the sense that their status can change if a bank’s capital levels fall below a specified level; they are convertible because in many cases they can be turned into equity – shares of the bank – if the shortfall gets big enough.

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In other cases, CoCos are written down in whole or in part. This buffer of debt and equity is intended to prevent taxpayers from having to shoulder the bill for a bank’s collapse, with CoCos giving banks a bigger capital cushion amid concern in the aftermath of the global financial crisis that many were over-leveraged.

For regulators, CoCos are a way for banks to be pulled back from the brink without the cost falling on taxpayers or existing shareholders. CoCos are also known as Additional Tier 1 (AT1) bonds.

2. How many does Credit Suisse have?

The Swiss lender’s holding company has 13 CoCos outstanding worth a combined US$17.3 billion, issued in Swiss francs, US dollars and Singapore dollars, according to data compiled by Bloomberg. That’s just above 20 per cent of its total debt pile.

Its biggest CoCos are denominated in US dollars – it has a US$2 billion perpetual note that can be called in July and a US$2.25 billion note with a first call in December. The securities are typically undated, meaning the bond has no defined maturity but lenders can call for repayment normally after around five years.

Investors price CoCos to their expected worth at their first call dates. When they are not called – in other words, when they are extended – prices tend to fall. The recent global market sell-off has driven corporate funding costs higher, meaning there is now a higher chance a lender could opt to skip a call because it could prove expensive to replace an existing note with a new one.

3. Should Credit Suisse’s CoCo investors be worried?

Potentially, yes, because CoCos are among the last in line to be paid if a bank fails and all of Credit Suisse’s outstanding CoCos are writedown ones rather than the type that can be converted into equity.

Yields on its CoCos have surged to distressed levels, alongside that of its other bail-in bonds. Credit Suisse has about 78 billion Swiss francs (S$113.3 billion) of holding company debt that includes both types of notes. If the regulator were to step in to protect depositors, then the CoCos would be written off and bail-in-able senior holding company debt converted to equity.

Under the international banking regulations known as Basel rules, big European banks need to meet a minimum requirement for the amount of their own funds and eligible liabilities, more commonly known as MREL, to support an effective resolution in the event of a collapse.

If a lender’s capital ratios fall below a predetermined level, then CoCos can be written down. They rank just behind common shares in the capital structure and are intended to absorb losses. Next in line is tier 2 debt, which will only stop paying investors when a bank is already defunct. 

4. Have CoCos ever been wiped out?

There has been one instance of a lender’s CoCos being wiped out previously. In 2017, Banco Popular Espanol was taken over by Spanish rival Santander after it was unable to fill a big capital hole. The event prompted regulators to forcibly write off its CoCos. If regulators push through a takeover of Credit Suisse by UBS, it’s possible that they would force a writedown of CoCos as part of the deal.

5. Why do Credit Suisse’s CoCos matter?

No one really knows how bad the fallout would be but Spanish lender Banco Popular’s CoCos wipeout shows that it is possible for the worst to happen. As Credit Suisse only has writedown AT1s outstanding, if it did fail then those notes would simply be written off.

CoCos were dreamed up by regulators after the 2008 financial crisis as a way of helping banks bolster capital ratios by tapping debt investors, so the risks of holding them are well-known. As were their attractions – as recently as early March, subordinated debt was seen as an attractive alternative to longer-duration bonds whose value was sinking.

6. How might regulators get involved?

If a bank runs into serious trouble, regulators can declare a Point of Non-Viability to try to protect depositors, limit a bank’s losses and avoid contagion, that is, having one bank’s troubles pull other banks down.

This would happen if regulators believed a lender’s balance sheet had deteriorated to a point of non-viability.

Since the financial crisis, lenders have had to make known their Common Equity Tier 1 (CET1) ratios of liquid holdings of cash and stock so that regulators can monitor capital strength.

The European Banking Authority has also conducted stress tests using the CET1 ratio – the higher the ratio, the better a lender’s financial strength. It’s unlikely regulators would let a situation carry on long enough for a bank’s CET1 ratio to fall below the required threshold.

However, even in the case of the collapsed Banco Popular, its CET1 disclosures failed to reveal the extent of its problems in a timely fashion, suggesting that fast-moving situations could make it difficult for regulators to fully gauge the extent of any serious problems.

European regulators’ reach extends to more senior debt as well: In the aftermath of the euro area debt crisis they introduced a so-called bail-in approach to avoid situations where taxpayers have to foot the bill of a bank rescue.

If Swiss authorities decide to impose losses onto bondholders as part of an intervention, about 60 billion francs of senior debt issued by Credit Suisse will be converted into equity. BLOOMBERG