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 in the Swiss bank's rescue by cross-town rival UBS.
Under the UBS deal, the Swiss regulator determined that Credit Suisse's AT1 bonds with a notional value of 16 billion Swiss francs ($17.35 billion) would be wiped out, a decision that stunned global credit markets and angered many holders of the debt, who believed they would be better protected than shareholders.
AT1 bonds, which can convert to equity, rank higher than shares in the capital structure of a bank. If a bank runs into trouble, bondholders will usually come before shareholders in terms of getting their money back.
AT1 bonds issued by other European banks tumbled on Monday as the treatment of Credit Suisse AT1 bondholders highlighted the risks of this type of debt.
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."