They’re called contingent convertible bonds, or CoCos — and are often described as high-yield investments with a hand grenade attached. The takeover of Credit Suisse by UBS Group AG included pulling the pin on US$17 billion of CoCos, also known as Additional Tier 1 (AT1) bonds. A legacy of the European debt crisis, they’re the lowest rung of bank debt, producing juicy returns in good times but taking a hit when a bank runs into trouble. While shareholders — often the first domino to fall in such situations — salvaged some value from the takeover engineered by Swiss banking authorities, Credit Suisse’s CoCo holders walked away with nothing. The move reverberated across bond markets, potentially inflating borrowing costs for other banks.  

WHAT ARE COCO BONDS?

They’re essentially a cross between a bond and a stock that helps banks bolster capital to meet regulations designed to prevent failure. They’re contingent in the sense that their status can change if a bank’s capital levels fall below a specified level; they’re convertible because in many cases they can be turned into equity — shares of the bank — if the shortfall gets big enough. In other cases CoCos are written down in whole or in part. 

WHAT ARE COCOS FOR?

They make up part of a buffer of debt and equity that’s intended to prevent taxpayers from having to shoulder the bill for a bank’s collapse. When they were dreamed up, CoCos were seen as giving banks a potentially bigger capital cushion without forcing them to issue new stock, amid concern that many were over-leveraged. 

HOW MANY DID CREDIT SUISSE HAVE?

The Swiss lender’s holding company had 13 CoCos outstanding worth a combined $17.3 billion, issued in Swiss francs, US dollars and Singapore dollars, according to data compiled by Bloomberg. That was just above 20% of its total debt pile. Its biggest CoCos were denominated in U.S. dollars — it had a $2b perpetual note that could have been called in July and a $2.25b note with a first call in December. CoCos are typically undated, meaning they have 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’re not called — in other words, when they’re extended — prices tend to fall. The recent global market selloff drove corporate funding costs higher, making it more likely a lender could opt to skip a call because it could prove expensive to replace an existing note with a new one.

WHY WERE CREDIT SUISSE’S COCOS WIPED OUT?

UBS agreed to buy Credit Suisse in a government-brokered deal aimed at containing a crisis of confidence that threatened to cascade across global financial markets. Because of the extraordinary government support, Swiss financial regulator FINMA triggered a “complete write-down” of the bank’s AT1 bonds in order to increase core capital, according to a statement on its website. In simple terms, banks are supposed to keep their capital above a minimum level needed 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. 

WHY IS THAT CONTROVERSIAL? 

In a normal writedown scenario, shareholders are the first to take a hit before AT1 bonds face losses, as Credit Suisse had also indicated in an earlier presentation to investors. However, under the terms of the government-brokered deal, Credit Suisse shareholders are set to receive 3 billion francs ($3.2 billion). The AT1 wipeout sent parts of the European credit market into a frenzy, with investors poring over the fine print of their holdings to understand if authorities in other countries could repeat what happened in Switzerland. 

AND WHAT’S THE ANSWER?

No other banks in Europe besides Credit Suisse and UBS had provisions that would allow for the full writedown of this kind of bond, according to senior Bloomberg Intelligence credit analyst Jeroen Julius. This feature allowed equity investors to maintain some value as bondholders were wiped out. The European Banking Authority, which oversees banks across the European Union, of which Switzerland is not a member, said in a statement that “common equity instruments are the first ones to absorb losses, and only after their full use would Additional Tier One be required to be written down.” The Swiss move still shook the $275 billion CoCo market, with Goldman Sachs Group Inc. ready to start trading claims in Credit Suisse’s AT1s. Here are the rules across Europe:

Credit Suisse AT1 notes will be written down to zero when the bank’s capital falls below 7% of its risk-weighted assets (known as a contingency event) or when measures to boost its capital are deemed to be unfeasible or insufficient to prevent insolvency (known as a viability event). 

Summarized from Credit Suisse’s AT1 prospectus dated June 16, 2022

EU

EU member states applying the bloc’s bank resolution tools must ensure that the shareholders of the affected bank bear first losses. The bank’s creditors must then bear further losses in “the order of priority of their claims under normal insolvency proceedings,” unless the EU directive states otherwise. 

Summarized from Article 34 of the European Banking Authority’s Bank Recovery and Resolution Directive.

U.K.

U.K. banking rules include a statutory order whereby shareholders and creditors must bear losses in a resolution or insolvency scenario. CET1 (equity) holders must be the first exposed to losses, followed by owners of AT1 instruments and then holders of Tier-2 debt. 

Summarized from a statement by the Bank of England. 

HAS THIS HAPPENED BEFORE? 

The Credit Suisse bond wipeout was the AT1 market’s biggest loss, far eclipsing the one other instance of a lender’s CoCos being wiped out. Back in 2017, junior bondholders of Spanish lender Banco Popular SA suffered an approximately €1.35 billion loss when it was absorbed by Banco Santander SA to avoid a collapse after failing to plug a big capital hole. On that occasion, the equity was also written off, while regulators forcibly wrote off its CoCos. 

WHAT’S THE IMPACT ON THE WIDER COCO MARKET?

The Credit Suisse debacle sent prices of AT1s issued by European banks tumbling, pushing average yields to almost double their level back in February. That’s likely to inflate future funding costs for lenders that typically used the bonds to bolster their financial resources at a lower cost than normal equity such as shares. There’s more than $258 billion of AT1 debt outstanding in Europe, excluding the chunk written off by Credit Suisse. 

ARE THERE COCOS AND AT1S IN THE U.S. TOO?

Not quite, but there are instruments with similar characteristics known as “preferred securities.” Like AT1s and CoCos, they rank above common equity in a bank’s capital structure but below senior debt and are designed to absorb losses before senior debt comes into play. When that happens, preferreds can be converted from debt to equity or their par value written down based on regulator discretion. AT1 and CoCos explicitly state the capital level that would trigger such a writedown or conversion. Preferreds pay dividends and, as with equity dividends, these are discretionary, not mandatory. If an issuer wants to stop paying preferred dividends, they typically also halt their common dividend, whereas issuers of AT1 and CoCos have the discretion to stop paying dividends regardless of the common dividend’s status.