Does the Credit Suisse Bailout Mark the End of the CoCo Bond Market?

In a dramatic move, UBS has taken over Credit Suisse in full with the support of the Swiss Confederation, the Swiss National Bank, and FINMA. As a result, the nominal value of all Additional Tier-1 debt of Credit Suisse, amounting to around CHF 16 billion, has been written down to zero. This decision strengthens the balance sheet of the newly combined bank but sparks controversy among market participants who question the use of AT1 debt in this bail-in process as evidenced by the severe losses suffered by exchanged trade funds tracking the performance of such instruments. The WisdomTree AT1 CoCo Bond UCITS ETF (CCBO, assets under management: $45 million) and the Invesco AT1 Capital Bond UCITS ETF Acc. (AT1, assets under management: $470 million) were down 6.87% and 8.52% for the week respectively, while the SPDR Refinitiv Global Convertible Bond UCITS ETF (GCVB, assets under management: $456 million) earned 0.68%.

AT1 debt instruments, also known as "CoCos" (Contingent Convertibles), were introduced in the aftermath of the 2008 financial crisis as a means for failing banks to absorb losses. These very risky securities with attractive returns in good times can be quickly converted into equity or written down entirely if the bank falls into financial hardship. The European market for such bonds is valued at around €255 billion.

Some industry experts argue that common equity instruments should be the first to absorb losses, with AT1 debt being used only as a last resort. By bypassing common equity and resorting directly to AT1 debt, the decision to take over Credit Suisse has raised concerns about the stability of the CoCo market.

It could now enter a deep freeze as investors reassess the risks associated with these bonds. The decision to use AT1 debt in the bail-in process of Credit Suisse is likely to have far-reaching implications for the banking industry. Banks will face more expensive funding for the foreseeable future at a time when economic growth is going down and lending conditions have already tightened markedly.