The government-backed deal for UBS to acquire Credit Suisse will trigger a complete write-down of the nominal value of all Credit Suisse additional tier 1 bonds. We believe Credit Suisse is most likely to be an isolated incident, while we have been reducing our portfolios’ exposure to Credit Suisse significantly over the past several months.
KEY TAKEAWAYS
- The government-backed deal for UBS to acquire Credit Suisse will trigger a complete write-down of the nominal value ($17 billion) of all Credit Suisse additional tier 1 bonds (AT1), also known as contingent convertible bonds (CoCos).
- We have been reducing our portfolios’ exposure to Credit Suisse over the past several months due to concerns we have held about the bank’s strategic direction.
- We are closely monitoring other banks for any liquidity vulnerabilities, but we believe fundamentals in the broader European banking sector remain healthy and Credit Suisse is most likely to be an isolated incident.
What happened?
UBS agreed to acquire Credit Suisse in a government-backed deal to prevent a bank failure that could create contagion across the global banking system. The transaction is an all-stock deal that values Credit Suisse substantially below its closing value of $8 billion on Friday, March 10. As part of the deal, the Swiss National Bank (SNB) has agreed to provide UBS a $100 billion line of liquidity.
The extraordinary government support will trigger a complete write-down of the nominal value ($17 billion) of all Credit Suisse additional tier 1 bonds (AT1), also known as contingent convertible bonds (CoCos).
CoCos emerged in the wake of the financial crisis, designed by policymakers outside the United States to lessen the need for government-funded bailouts of financial institutions. These hybrid fixed income instruments help banks satisfy capital requirements, while providing issuers with an attractively priced form of equity-like capital. CoCos now represent roughly one-quarter of the global preferred securities universe.
CoCos have provided some of the highest yields among global fixed income securities, in part as compensation for their deep subordination in a company’s capital structure. Those securities allow for CoCos to convert to equity or to be written down in the event that capital falls below a specified level.
The terms of Credit Suisse CoCos (and generally those of Swiss banks) are somewhat unique in that they do not allow for a conversion to common equity or a temporary write-down; they called for a full and permanent write-down.
Credit Suisse had relatively strong capital levels, liquidity and asset quality. However, mounting deposit outflows, stemming from a lack of confidence in the bank from depositors, led to a liquidity crisis at Credit Suisse that convinced authorities to take action and prevent potential damage to Swiss and other global banks.
The extraordinary government support will trigger a full and permanent write-down of the nominal value of all Credit Suisse additional tier 1 bonds.
What is Cohen & Steers’ exposure and what actions have you taken?
We have been reducing our portfolios’ exposure to Credit Suisse over the past several months, dating back to October 2022 and stemming from concerns we had about the bank’s operational challenges and strategic direction. In fact, the investment across all our portfolios was reduced by more than 60% from October 1, 2022, to Friday, March 17, 2023.
Cohen & Steers holds Credit Suisse preferred securities in two of its U.S. registered mutual funds, representing the following as a percentage of assets in those funds as of December 31, 2022:
- Cohen & Steers Preferred Securities and Income Fund: 2.3%
- Cohen & Steers Low Duration Preferred and Income Fund: 1.3%
The holdings in all of our funds, including those mutual funds, ranged from 1.3% to 2.3% as of December 31, 2022.
As of March 17, that same exposure was:
- Cohen & Steers Preferred Securities and Income Fund: 0.5%
- Cohen & Steers Low Duration Preferred and Income Fund: 0.2%
The holdings in all of our funds, including those mutual funds, ranged from 0.2% to 0.5% as of March 17, 2023.
What are the broader implications for European banks?
Fundamentals in the broader European banking sector remain healthy, and we believe Credit Suisse is most likely to be an isolated incident. European banks are governed by strong regulations that are uniformly applied and have higher capital and liquidity coverage ratios relative to their peers in the United States.
The crisis at Credit Suisse was one of depositors’ lack of confidence in the bank that followed a string of missteps in recent years that ranged from scandals to litigation to rapidly declining profitability amid outflows in its assets under management. Most recently, the firm’s auditor issued an adverse opinion citing weakness in the bank’s internal controls.
European regulators have since issued statements intended to reassure markets that the events at Credit Suisse, in which AT1 holders absorbed losses before equity holders, were extraordinary. The Single Resolution Board, European Banking Authority, and European Central Bank said that their actions in future circumstances will be guided by an established framework in which “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 Bank of England issued a similar statement.
That said, we are closely monitoring all companies for any liquidity vulnerabilities and will look to reduce exposures where needed. We also expect CoCos will remain under pressure in the near term on the news of the full write-down. The main consequence should be a wider credit spread differential between CoCos and senior/subordinated debt.
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Important disclosures
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Risks of investing:
Preferred securities. Diversification does not ensure a profit or protect against loss. Investing in any market exposes investors to risks. In general, the risks of investing in preferred securities are like those of investing in bonds, including credit risk and interest-rate risk. As nearly all preferred securities have issuer call options, call risk and reinvestment risk are also important considerations. In addition, investors face equity-like risks, such as deferral or omission of distributions, subordination to bonds and other more senior debt, and higher corporate governance risks with limited voting rights. Preferred funds may invest in below-investment-grade securities and unrated securities judged to be below-investment-grade by the Advisor. Below-investment-grade securities or equivalent unrated securities generally involve greater volatility of price and risk of loss of income and principal and may be more susceptible to real or perceived adverse economic and competitive industry conditions than higher-grade securities.
Risks of preferred securities differ from those of other investments. In the event of bankruptcy, a company’s preferred securities are senior to common stock but subordinated to all other types of corporate debt. Corporate bonds sit higher in the capital structure than preferred securities and therefore, in the event of bankruptcy, will be senior to preferred securities. Municipal bonds are issued and backed by state and local governments and their agencies; the interest from municipal securities is often exempt from state and local income taxes. Treasury securities are issued by the U.S. government and are generally considered the safest of all bonds since they are backed by the full faith and credit of the U.S. government as to timely payment of principal and interest; U.S. Treasury interest is generally exempt from state and local income taxes.
Contingent capital securities (CoCos). CoCos are debt or preferred securities with loss absorption characteristics built into the terms of the security, for example a mandatory conversion into common stock of the issuer under certain circumstances, such as the issuer’s capital ratio falling below a certain level. Since the common stock of the issuer may not pay a dividend, investors in these instruments could experience a reduced income rate, potentially to zero, and conversion would deepen the subordination of the investor, hence worsening the investor’s standing in a bankruptcy. Some CoCos provide for a reduction in the value or principal amount of the security under such circumstances. In addition, most CoCos are considered to be high yield securities and are therefore subject to the risks of investing in below-investment-grade securities.
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