Just over $17 billion worth of Credit Suisse bonds, known as Additional Tier 1 or AT1, debt will be written down to zero on the orders of the Swiss regulator as part of a rescue merger with UBS (UBSG.S).

Under the deal, holders of Credit Suisse AT1 bonds will get nothing, while shareholders, who usually rank below bondholders in terms of who gets paid when a bank or company collapses, will receive $3.23 billion.

AT1 bonds issued by other European banks fell sharply on Monday as the treatment of Credit Suisse AT1 bondholders highlighted the risks of investing in this type of debt.

Here are some of the implications of the Credit Suisse AT1 bond write-down — and how hedge funds are profiting.

WHAT IS AN AT1 BOND?

AT1 bonds — a $275 billion sector also known as "contingent convertibles" or "CoCo" bonds — act as shock absorbers if a bank's capital levels fall below a certain threshold. They can be converted into equity or written off.

They make up part of the capital cushion that regulators require banks to hold to provide support in times of market turmoil.

They are the riskiest type of bond a bank can issue and so carry a higher coupon.

If AT1s are converted into equity, this supports a bank's balance sheet and helps it to stay afloat. They also pave the way for a "bail-in", or a way for banks to transfer risks to investors and away from taxpayers if they get into trouble.

WHAT HAPPENED TO CREDIT SUISSE AT1's

AT1s rank higher than shares in the capital structure of a bank. If a bank runs into trouble, bondholders will rank above shareholders in terms of getting their money back.

In Switzerland, the bonds' terms state, however, that in a restructuring, the financial watchdog is under no obligation to adhere to the traditional capital structure, which is how bondholders lost out in the Credit Suisse situation.
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Credit Suisse AT1 holders, therefore, are the only ones not to receive any kind of compensation. Under the rescue deal, they rank lower than shareholders in the bank, who can at least get UBS' takeover price of 0.76 Swiss francs ($0.8191) per share.

WHO RANKS HIGHER

European regulators said on Monday they would continue to impose losses on shareholders before bondholders - unlike the treatment of bondholders at Credit Suisse.

Separately, the Bank of England also said that Britain had a clear statutory order in which shareholders and creditors of failed banks bear losses, with AT1 instruments ranking ahead of other equity instruments and behind tier two bonds in the hierarchy.

It is not the first time that the treatment of AT1 bonds in a bank overhaul has caused controversy. A dispute over the write-off of around $1 billion of AT1 bonds issued by India's Yes Bank (YESB.NS) in March 2020 after the Reserve Bank of India initiated a restructuring of the lender is currently subject to court proceedings.

WHAT IT MEANS FOR INVESTORS

Fixed income investors were shocked by the Swiss regulator's decision to make Credit Suisse write down its AT1 debt to zero. But if they had read the fine print in the bond prospectus, they would not have been.

One bank adviser and a bond investor said the Swiss government's actions were legal since the type of AT1 bonds issued by Credit Suisse could be subject to a complete write- down.

But the price of other banks' AT1 bonds have dropped as investors have panicked, fearing their bonds, which were meant to provide more protection than shares, could face the same fate.

WHAT IT MEANS FOR THE BROADER MARKET

The decision to write down Credit Suisse AT1 bonds to zero is viewed as negative for the AT1 bond market globally.

Analysts reckon investors will be much more cautious about buying AT1 bonds in the future, making it tougher for banks which need to raise money in bond markets to meet regulatory requirements.

Bid prices on AT1 bonds from banks, including Deutsche Bank, HSBC, UBS and BNP Paribas dropped 9-12 points on Monday, sending yields sharply higher, data from Tradeweb showed.

HEDGE FUNDS SWOOP IN

Distressed debt investors and large hedge funds are buying up Credit Suisse additional tier-1 bonds at rock-bottom prices after they were written down to zero.

The bonds, now trading at about 0.03 cents on the dollar, have become an opportunity for hedge funds, which are taking punts that the merger of UBS/Credit Suisse might not proceed or that the Swiss regulator might even reverse its decision, six traders and dealmakers said.

Robert Southey, a broker at Southey Capital in London, said bonds worth several hundred millions dollars in face value had traded since Sunday afternoon, mainly between large U.S. investors, (referring to the nominal value of the bonds).

As the bonds are publicly traded, opportunistic buyers can hoover them up from funds and private banks looking to offload, said Southey.

Buyers have included a mixture of hedge funds and deep distressed debt funds, which Southey expected would need to hold the bonds for an extended period before they paid off.

Some of those buyers intend to join groups that would litigate to improve odds on cashing in on the bonds, Southey said. Law firm Quinn Emanuel is talking to AT1 holders about possibly recouping some of their losses via the courts.

"We've heard of other law firms receiving many inbound calls from holders and potential buyers," he added.

Louis Gargour, the chief investment officer and managing partner of $550 million hedge fund LNG Capital, said that legal action could increase the spoils for investors swooping on Credit Suisse AT1s, but taking advantage of the sell-off in similar bonds issued by other banks was the wiser trade.

"The most compelling trade is other large independent well-capitalised European institutions such as Deutsche Bank, Societe Generale, and Intesa where you can achieve significant long-term yields by taking the view that AT1s will not be converted into equity," said Gargour.

European regulators, including the European Central Bank, said on Monday they would continue to impose losses on shareholders before bondholders.

"Regulators have an interest in ensuring that the AT1 market continues to function, as these instruments are used by banks to maintain healthy capitalization levels," said Shannon Kirwin, associate director at Morningstar.

"It's quite possible that we will see demand from buyers of subordinated bank debt to have more explicit protections written into these bond prospectuses in the future."

($1 = 0.9223 Swiss francs)