In a further complication, to an already tense situation, it was decided that Credit Suisse’s AT1 bonds would be wiped under the acquisition.
What is happening in bond markets?
As you will no doubt be aware Credit Suisse has now been taken over by its biggest rival UBS, in a deal struck by the Swiss regulator last weekend.
The bank has long been afflicted by a host of problems, caused by poor lending, scandals, and high levels of staff turnover. More recently, it saw a serious decline in profitability and has suffered significant cash withdrawals by investors and depositors, worried about its viability and reputation.
In a further complication, to an already tense situation, it was decided that Credit Suisse’s AT1 bonds would be wiped under the acquisition. These bonds were introduced after the 2008 global financial crisis in order to increase a bank’s capital buffers in a crisis, when they would convert into equity. In theory, in the event of any wind up of a firm, these should rank above equity in the capital structure and should, therefore, be paid before shareholders.
This decision to up-end the natural order was taken by the Swiss regulator, no doubt with some urging from UBS, who used a hitherto overlooked clause to allow them to do so. This sent shivers through the entire $260bn AT1 bond market and led to regulators in Europe, the UK and US denouncing the move.
What has happened to Credit Suisse bonds and the broader AT1 bond market?
Interestingly, the senior bonds issued by Credit Suisse have risen in value since the deal was announced. Much of the wider AT1 bond market initially saw prices fall around 20% before slightly rebounding. Credit Suisse’s AT1 bond are pricing at near zero, as would be expected. The outlook for the AT1 bond market looks difficult for now and is likely to remain under pressure, although the reaction from other regional regulators has been welcomed by investors.
What exposure have we got in the Square Mile Portfolios?
| Bonds | SVB Exposure | CS Exposure | CS AT1 | Total AT1 | Banks | |
|---|---|---|---|---|---|---|
| Representative SM Balanced Portfolio – Fixed Income Holdings | 20.00% | 0.00% | 0.05% | 0.02% | 0.44% | 2.68% |
As can be seen in the above table, our exposure to Credit Suisse bonds is minimal, and even less so to their AT1 bonds. We have also included the exposure to the failed US bank, Silicon Valley Bank (SVB), for completeness. The AT1 market is one that, up until now, some fund managers had been positive on given the yields on offer, though we expect them to tread more cautiously for the moment. Importantly, it is only Credit Suisse’s AT1 bonds that have been written off and not the AT1 bond market itself.
What is the outlook?
Interestingly, some fund managers now have a more favourable view on senior bank bonds issued by Systemically Important Banks, those deemed too big to fail. These bonds are still trading cheaply when compared to earlier in the year and are likely to be beneficiaries of deposit flows away from smaller rivals.
As we have written before, we regard the issues that have appeared in the US and European banking systems as being unconnected. Nevertheless, as the world rapidly adjusts to higher interest rates and stricter financial conditions there are likely to be further stresses and surprises to come. In our view, the entities most at risk are the deeply indebted and those vulnerable to asset value write-downs. Two areas to watch closely would be real estate and private equity, where the cost of funding is increasing (and likely more so after recent events) and the valuations of assets are being reduced sluggishly and the numbers of buyers thinning out. We have no direct exposure to either asset class.
We do expect more volatility to come but take some comfort from the fact that we are already some (or most of the) way through the monetary normalisation process; albeit it has a lagged impact. Furthermore, it has been impressive to see the world’s regulators react to each situation quickly and with decisiveness. As ever, Square Mile’s Investment Management and Research teams continue to remain vigilant and whilst it appears as if the worst of the storm has passed, we are not complacent. We shall continue to keep you up to date with any further, significant developments.
The Investment Management Team, Square Mile Investment Services
23 March 2023
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