Stockholm (HedgeNordic) – As part of the takeover of Credit Suisse by UBS, Swiss financial regulator FINMA instructed the credit-stricken bank to write down 16 billion Swiss francs of additional tier-1 (AT1) bonds. This puts the traditional, common-sense pecking order hierarchy in turmoil as equity shareholders are set to receive payouts from the takeover. This prompted AT1 investors to threaten legal action and other European financial authorities to distance themselves from the decision of the Swiss Financial Supervisory Authority.

“I do not believe this will be the default mode of resolutions of troubled banks going forward,” argues Magnus Vie Sundal, a portfolio manager who focuses on investing in AT1 securities issued by Norwegian savings and commercial banks. This decision by FINMA does not necessarily set a precedent in the AT1 market, according to Vie Sundal. “Given the responses from actors such as the European Banking Authority and the Bank of England, I guess not,” argues Borea Asset Management’s portfolio manager. “Regulators seem eager to distance themselves from the Swiss practice.”

“I do not believe this will be the default mode of resolutions of troubled banks going forward.”

To calm the market and investors, the European Banking Authority together with the European Central Bank issued a clarification saying that common equity instruments are the first ones to absorb losses, and only after their full use would additional tier-1 be required to be written down. Magnus Vie Sundal goes on to emphasize that “you can never hedge yourself against political risk, and banking crises remind us of how fluid the rulebook can be, if the situation is critical enough.” While one can never predict and protect against this type of risk, in the long term, the main victim of this situation is the Swiss banking sector and the ability of the remaining Swiss major bank to raise additional tier-1 capital, considers Vie Sundal.

“You can never hedge yourself against political risk, and banking crises remind us about how fluid the rulebook can be, if the situation is critical enough.”

What are AT1 Securities?

For background, AT1 securities represent a relatively young asset class born out of the financial crisis of 2008, acting as a critical instrument in regulators’ post-crisis bail-in strategy. The goal of these securities is to improve banks’ ability to mitigate risks and limit the reliance on the public purse during a banking crisis. AT1 notes represent hybrid securities that absorb losses when a bank’s regulatory capital ratio falls below a previously agreed level by converting into common equity or suffering a principal write-down before taxpayers have to step in.

In Credit Suisse’s case, the investments of AT1 holders were written off, while common equity shareholders are set to receive a payout from the takeover. This subordination of AT1 bondholders to shareholders can cause some AT1 investors to reassess the pricing of AT1 bonds due to the higher risks associated with these securities. “It’s easy to subscribe to the narrative that funding costs should increase going forward, due to increased risk related to the AT1 product,” acknowledges Magnus Vie Sundal. “While it clearly has been a reminder of the risks involved, I’m not sure how correct this narrative is. We’ve seen a swift recovery in market prices, although I would expect volatility to persist for some time, given how quickly markets have improved in recent days,” he elaborates. “The market tends to view such events as more game-changing than they turn out to be, in the longer run.”

“Overall I believe AT1s in high-quality banks will be an attractive product also going forward.”

The events of the past two weeks that initially appear idiosyncratic seem to arise from the same underlying factor, namely rising interest rates, according to Vie Sundal. “I do believe funding costs, in general, could be impacted by volatility for some time to come,” considers the portfolio manager. Vie Sundal and his team at Borea Asset Management, who manage a fund that invests exclusively in AT1 securities, focus on one underlying question: will coupons be paid, and hybrids called? “If so, all else is noise and higher yields and lower prices an opportunity rather than a threat,” argues Vie Sundal.

With Borea Obligasjon mainly exposed to the domestic Norwegian market of AT1 securities, which is generally more stable in pricing than the EUR/USD markets, the fund managed to avoid large losses. “We have instead used the opportunity to increase our exposure to Nordic banks in the USD T1 market,” says Vie Sundal. “Overall I believe AT1s in high-quality banks will be an attractive product also going forward.”