CoCo Bonds’ Write-Down Risk Is Real

Blog post
3 min read
Gergely Szalka
March 24, 2023
  • The wipe-out of Credit Suisse's AT1 bonds (or contingent convertibles) has been controversial among investors, but this is in fact what AT1 bonds are designed to do: to absorb losses before a bank becomes insolvent.
  • Since AT1 bonds were introduced in 2008, there have only been a few cases where their loss-absorbing mechanism has been triggered, which may have lulled investors into a false sense of security.
  • Considering AT1 bonds to have a direct link to a bank's equity value ensures that their write-down risk is captured, and may provide a more complete picture of AT1 risk.
UBS Group's arranged takeover of Credit Suisse AG involved heavy losses for the latter bank's shareholders. But a more controversial part of the deal is the total write-down of bonds designated as additional Tier 1 (AT1) — also commonly known as contingent-convertible, or coco, bonds — while shareholders will receive more than USD 3 billion. This imposition of losses on these bondholders inverts the usual hierarchy in which shareholders take losses before bondholders because the terms of the bonds in question contained provisions that allow for total write-down in a "viability event."1 But that's the nature of coco bonds. They are designed to absorb losses to bolster a bank's capital ratio, and avoid a bailout funded by taxpayers. Investors have been earning additional yield to compensate for this risk, as shown in the exhibit below.
Cocos offer additional yield to compensate for their unique risk profile
Since regulators introduced this type of loss-absorbing bond to promote financial-system safety after the 2008 global financial crisis, there have been only a few cases when write-down or conversion to equity has been triggered (notably when Banco Santander SA took over Banco Popular in rather similar circumstances2). This may have lulled investors into a false sense of security about AT1 bonds' risks, which Credit Suisse bondholders learned are very real.
Can the risks be measured?
Cocos' loss-absorption mechanics are complex and somewhat untested — which presents challenges in measuring and managing those risks. An important feature is that AT1 bonds' loss-absorption risk increases just as the capital position of a bank deteriorates. To capture this risk, which is called "negative convexity," MSCI's model for AT1 bonds makes the equity of the issuing bank an explicit risk factor. As the exhibit below shows, on March 16 Credit Suisse's AT1 bonds displayed elevated risks due to their equity exposure. Traditional risk management focusing on credit-spread risk would have missed the elevated, coco-specific risks. Following the collapse of Credit Suisse, AT1 bonds issued by BNP Paribas SA also displayed higher equity risk, reflecting the heightened sense of risk in the overall coco-bond market.
Equity risk became the primary source of risk for Credit Suisse's AT1 bonds
The author would like to thank Dimitrios Karkantzos for his contribution to this blog post.
Further Reading
Don't Let CoCo Bond Risk Sneak Up on You How Far Could the Banking Panic Spread The Silicon Valley Tantrum Santander's Coco extension: The New Market Norm? Senior bonds in name only Are convertible bonds more like equities?
Gergely Szalka
Gergely Szalka
Executive Director, MSCI Research

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1 https://www.ft.com/content/4f0c9cc8-192c-4b2b-bd78-4943d23b17a32 A key difference between Banco Popular and Credit Suisse: while Credit Suisse shareholders walked away with more than USD 3 billion, Banco Popular was sold for 1 Euro. So equity was wiped out at the same time as AT1 bonds.

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