Home / Opinion / Market’s goldfish memory on display in oversubscribed UBS CoCo deal

The Swiss bank's $3.5 billion issue of contingent convertible bank capital drew 10 times as many investors as it needed, showing the market has already forgotten how holders of these bonds fared in the case of the collapsed Credit Suisse.

Among the more touch-and-go moments for markets in a year that has lurched from one crisis to the next was the banking upheaval that began with regional US bank failures and culminated in UBS’ emergency absorption of rival Credit Suisse in March. Apparently, it’s a moment investors have already gotten over.

The UBS-Credit Suisse deal came with a controversial component: the write-down of US$17 billion of Credit Suisse contingent convertible capital Additional Tier 1 (AT1) bonds, a type of hybrid bank debt known as “CoCos”, leaving buyers of those notes holding worthless equity, to the shock of many of them.

But by November 8, when UBS brought its own new issue of AT1 bonds to the market, the cacophony of commentary about the treatment of the Credit Suisse bondholders had fallen silent. In its place was demand: the US$3.5 billion issue at 9.25 per cent yield was more than 10 times oversubscribed.

And while the fundamentals around these hybrid instruments have not changed – and the levels they trade at generally do not justify their risk – the response to UBS’ massive deal shows investors are more than ready to jump back into CoCos, with most media trumpeting the transaction as a revival of the AT1 market.

One commentator who does see through the veil on CoCos is Shard Capital’s Bill Blain, who provides financial markets commentary on the Blain’s Morning Porridge blog. After news of the UBS issue broke, Blain, a UK-based market strategist focussed on fixed income, said it proved one of his favourite investment mantras: that the market has no memory.

In a November 9 post, Blain explained that AT1 CoCos are billed as alternatives to stock investments, offering equity-like returns with less volatility than the underlying equity, with greater downside protection against all but the most extreme events.

But in fact they act far more like equity instruments than debt, with risks of a liquidity event triggering conversion and write-down. Investing in these complex instruments requires a real understanding of the capital structure, the risks it covers and the bank’s ability to manage those risks.

“The fundamental truth of the contingent capital AT1 market is these instruments have all the upside of bonds, and the downside of equity: meaning you will never get more than the coupon in returns, and if it goes badly wrong you lose ahead of equity holders – putting AT1 holders in the deepest bilges of the subordination ladder,” Blain wrote in September after UBS announced its plans.

And now, European banks and others piling back into new AT1 debt issuance, thanks to UBS’ impressive orderbook. Barclays was quick to follow; Westpac on Monday announced it’s raising A$750 million in AT1 notes. And by the way, two investors in the doomed Credit Suisse CoCos were reportedly among the bidders for UBS’ offering.

Speaking with The Inside Investor, Blain explained that “institutions buy these [instruments] because they think the yield is too good to miss – but they don’t really factor in all the bank risks involved, in my opinion.” Crucially, there are still significant risks hanging over the entire banking sector, with corporate and consumer defaults and losses set to rise.

“Although banks have significantly de-risked themselves – now they largely originate risk to sell to the asset management sector in the form of corporate bonds and packaged consumer receivables – they are still very vulnerable to economic forces,” Blain wrote.

So what does all this mean? It’s mostly banks and institutional investors that buy CoCos and other hybrid paper, and banks have reserves they can tap into in times of crisis. But the value of those reserves is often tied to interest rates, making them vulnerable to deep discounts if a sale is forced. “If banks are forced to absorb the unrealised notional losses on hold-to-maturity bond portfolios, the quantum of losses will swiftly swamp their entire capital reserves,” Blain warned.

Moreover, the banks’ scramble to issue new AT1 debt could also be attributable to their recognition of another of Blain’s market mantras, he said, referring to raising capital “when you can, not when you need to”.

“Banks can sense where the economy is going from the metrics on their loan books – they know winter is coming.”

Luckily, regulators largely prevent retail investors from directly accessing investments deemed too dangerous, including CoCos. But despite the rocky moments this market has experienced just this year, the recent show of demand – from banks and other key institutions playing an outsized role in the Australian economy – makes their potential impact clear.

And as Blain says, “never forget, when an investment bank tells you complex financial instruments are cheap and you should buy them, your first thought should be how long and wrong they are.”