European banks using AT1 bonds to increase safety buffer

European banks using AT1 bonds to increase safety buffer

Swiss regulators announced on March 19 the annihilation of more than $17 billion of Credit Suisse Group AG's additional Tier 1 bonds, or AT 1 s, shocking investors as shareholders were paid out before some bondholders. AT 1 bonds deliver higher yields than many comparable assets, which makes them attractive to investors willing to take the risk.

European banks are using AT 1 bonds as a way to increase safety buffers. Following the 2008 financial crisis, many countries in Europe signed on to a regulatory framework called Basel III, under which they passed laws requiring banks to maintain a financial cushion during a downturn.

When adjusted for risk, the capital buffer must meet minimum levels and must be grouped into two tiers. The capital of Tier 1 is made up of equity, while the capital of Tier 2 can be made up of other securities. At 1 bonds can make up a part of the bank's core regulatory capital requirements, because they are considered in a separate category of Tier 1 instruments.

While AT 1 s pay high interest to bondholders, their mechanics can make them a risky investment.

As with traditional bonds, issuers of AT 1 make regular interest payments to investors. But AT 1 s have triggers that allow the issuing bank to convert, reduce or completely erase the bond's principal value in order to preserve its Tier 1 capital.

AT 1 s have different trigger mechanisms depending on how they are set up. One of the mechanisms is to tie the trigger to a bank equity relative to its risk-weighted assets. If the bond falls below a preset threshold, the bank may convert it to shares. Converting the bond to equity eliminates the bank's liabilities on AT 1.

Another mechanism that banks can use with AT 1 s is to write down or write off the value of bonds. This removes the bank's liabilities on AT 1.

It can help absorb some of the costs of the bank's failure or sale, as happened at Credit Suisse.

One risk associated with AT 1 s is that regulators have the power to convert bonds to equity or reduce the value of bonds. In UBS Group AG's emergency takeover of Credit Suisse, Swiss regulators decided to write off about 16 billion Swiss francs, or about $17 billion, in AT 1 bonds.

According to research firm Dealogic, Credit Suisse is just one European bank to have issued AT 1 s in recent years.