In 2014, the UK's Financial Services Authority (FSA) banned the sale of AT1 bonds, or CoCos, to retail investors. The reason?
These instruments are too complex, and retail investors are often unable to fully understand the risks involved. These products, which have a coupon and a maturity like bonds, are "special animals". Created in the aftermath of the financial crisis, their purpose is to stabilise banks' capital in times of stress.
As a result, the issuer can convert them into shares or even cash in the event of financial difficulties. This risk is the easiest to understand; the others, especially the legal ones, require an in-depth reading of hundreds of pages of prospectus, which are not always easy to grasp. Fast forward 10 years.
The issue is still the same: the misunderstood risks associated with AT1 bonds, but this time it's the Australian Prudential Regulation Authority (APRA) that is considering banning these instruments, not from certain investors, but from its market.
According to APRA, these instruments are not fulfilling their stabilising role because of their complexity, potential legal challenges and the risk of contagion. While the Australian case is unique because of the unusually high proportion of AT1s held by retail investors, it is making headlines.
The Credit Suisse case shocked the world when FINMA exercised its option to order the write-off of CHF 16 billion of Credit Suisse Cocos. This was a first for the Cocos market and a unique event in Switzerland, as most European structures have conversion clauses into shares or cash. The shockwave caused the Cocos market to drop by 15% in March 2023. It has since recovered, with the index up almost 40% since that low. Issuers are riding the wave, buying back their existing issues - almost $4.5bn mid-September, a record compared to the $1.8bn peak in 2022 - and issuing new AT1s on better terms.
By mid-September 2024, 221 new Cocos had been issued, already exceeding the levels of the last two years. But is it only a question of demand? Not quite. The European Banking Authority (EBA) has also helped by clarifying certain rules. Until recently, when issuers bought back part of their Cocos, the remainder in circulation lost its regulatory capital status. It thus became debt, which cost the issuer dearly.
Since April, the EBA has confirmed that the balances retain their status, paving the way for partial buybacks and new issues. This approach differs markedly from Australia's, which has its own specific reasons. To the potential question of which is better, the answer is simple: it depends. The main thing to remember is that the greatest risk you can take is not knowing how to identify and understand it.
