T K Arun
Recognise AT1 bonds as insurance, rather than pure debt. Once AT1 bonds are understood as insurance by a bank that is still a going concern, against a calamitous loss, the expectation that they should be bailed in only after equity is written off would disappear
The high-decibel angst of investors in Credit Suisse’s Additional Tier 1 (AT1) bonds that were fully written off before selling the bank to rival UBS for $3.23 billion resonates with investors in Yes Bank’s AT1 bonds, who are currently litigating against such a write-off at the hands of the RBI-appointed administrator, before the troubled bank was transferred to State Bank of India.
The Swiss banking regulator chose to write off Credit Suisse’s $17 billion of AT1 bonds in their entirety. The European banking regulator came out with a statement that has muddied the waters further, saying that in Europe, equity would necessarily take the hit before AT1 bonds do.
The Bank of England also came out with a statement that some have interpreted to be in consonance with the European regulator’s position. But this is what the Bank of England said: “AT1 instruments rank ahead of CET1 (Common Equity Tier 1) and behind T2 in the hierarchy. Holders of such instruments should expect to be exposed to losses in resolution or insolvency in the order of their positions in this hierarchy.” This would suggest that Tier 2 and Additional Tier 1 bonds would be fully written off before equity is touched.
An insurance product
The trouble comes from conflating Additional Tier 1 bonds with the ordinary kind of bonds issued by a corporate entity. In the case of normal bonds, it is entirely legitimate to expect equity to absorb the loss before debt, and bondholders have seniority over equity holders. But AT1 bonds are not normal bonds. They are insurance.
Catastrophe bonds have been around for some time. These bonds are issued to insure against catastrophic events such as hurricanes. They offer relatively high rates of return but carry the risk that they would subside, that is, be written off, in full or in part, in case a hurricane does strike and the bond proceeds have to be dipped into, to pay off the insured amount.
Additional Tier 1 bonds are what are called contingent convertible bonds, meaning they can be converted into equity that is bailed in to absorb loss, depending on specified contingencies that are triggered. But to compensate for this risk, they offer superior rates of return. As against a triple-A rated corporate bond yielding 4 percent plus in Europe, AT1 bonds offered yields close to 8 percent, in February, prior to the terminal crisis at Credit Suisse. Now, the yield on AT1 bonds has soared to 13.5 percent, according to Bloomberg. Getting double the yield on normal corporate bonds was to compensate for taking the risk of being written off/converted into equity that is written off to absorb loss.
Once AT1 bonds are understood as insurance by a bank that is still a going concern, against a calamitous loss, the expectation that they should be bailed in only after equity is written off would disappear. Perhaps, the nomenclature of these bonds should change to make their difference from normal bonds clear. CoCo bonds, short for contingent convertible bonds, does not quite cut it. Call them catastrophe bonds for the financial sector or FinCat bonds.
High-risk asset class
Will any investor interest remain, once AT1 bonds are clearly recognised as an insurance instrument hedging against a financial calamity, rather than a regular bond, albeit with a superior rate of return? Some people have, following the writing off of the entirety of Credit Suisse’s AT1 bonds, predicted the demise of the asset class itself. This view is extreme.
The fact remains that there are takers for Catastrophe or Cat bonds. Investors buy into them in the full knowledge they are meant to offer insurance against hurricanes in hurricane-prone territory — no one would buy hurricane insurance in a location with no hurricanes. This is because these bonds offer higher-than-normal rates of return. Large funds can, not just afford to, but also benefit from allocating a tiny slice of the corpus to such high-risk, high-reward instruments.
How high the rate of return should be would depend on the risk profile of the bank in question. You do expect the insurance premium to vary, depending on whether the customer is in his healthy twenties or in the wheezing seventies.
Arguing in the Supreme Court against the Bombay high court’s ruling setting aside the writing off of Yes Bank’s AT1 bonds, the RBI said that this step was crucial to elicit SBI’s interest in the troubled Yes Bank. In India, we do not allow banks to go totally belly up. The RBI engineers some bailout.
In the case of a bank that is being resolved, there might be scope to debate the hierarchy of the capital instrument up for being written off to absorb the losses of the bank under resolution. But, in the case of a bank that is being sold to another bank forced, by the banking regulator, into the shining armour of a white knight, there is little doubt that having to service a load of AT1 bonds of the troubled banks, while also having to absorb built-up losses, would be a definite disincentive.
AT1 bonds were thought up in the aftermath of the global financial crisis of 2007-09. They represent an extremely useful tool to hedge against risk. That usefulness would be eroded by treating AT1 bonds on par with normal bonds.
The solution is to change the nomenclature of these insurance instruments. While the offer document makes it clear, albeit in small print, that they are liable to be bailed in first, before equity is, use of a term that does not conflate these insurance products with normal debt would spare everyone much confusion and agony. Call them bonds, FinCat bonds.
This article was first published in Money Control as AT1 bonds need a name change. Call them FinCat bonds, catastrophe bonds for the financial sector on March 28, 2023.
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