What do cheese and hybrids have in common?

Charlie Callan, CFA  |   20th Apr 2023 | 7 min read

There are many varieties of cheese. Some cheeses have holes in them, some do not. There are also many varieties of hybrids, some of these also have holes in them, as Credit Suisse noteholders have found out. We draw this analogy out further below, inspecting what holes were present and compare this to the Australian hybrid and cheese market.

Coco Pops

The failure of something as solid and Swiss as Credit Suisse (CS), is a momentous occasion in financial markets. In the library of bank defaults, confidence of management was never something in short supply. Banks are in the confidence business due to the nature of fractional banking, where you lend more than you borrow. Risk happens fast and losing the confidence of your funders, whether retail or institutional, has fast and far-reaching implications. Whilst CS’s equity has been under pressure for years, the own goal scored by its biggest shareholder and the collapse of three banks in the US, saw risk happen fast for a Globally Systemic Important Bank. Failing to trade or clear with CS, alongside a massive outflow of deposits that evaporated the CHF 50 billion (US$54 billion) in liquidity provided to it, has tipped the bank to the point of non-viability via another old-fashioned bank run—the third now in two weeks. What has been particularly surprising has been the treatment of Credit Suisse hybrid holders—who, despite appearing to sit higher in the priority of claims than ordinary equity, even within CS branded decks, will receive a lower resolution return than equity holders. US$17 billion of hybrid notes will all be zeroed, whereas common equity will receive 1 share of UBS per 22.48 shares of CS owned—equivalent to CHF 3 billion. Noting that CS raised CHF 4 billion of equity at the end of last year. Regulatory capital hybrids are complex instruments. This is a commercial lawyer’s dream—big packs of legalese, filled with definitions and double negatives. At the core, this is what a hybrid and/or bond is, it is a contract. It is not a share of ownership—like in an equity stock. Regulatory capital hybrids are often referred to as a CoCo, standing for contingent convertible. Credit Suisse CoCo’s have popped—but they have not been converted as the name suggests—this is what has shocked fixed income markets.

Cheese and hybrids

We will attempt to simplify the complex here regarding global hybrids, as our motto demands. To do so, we will compare hybrids to cheese. There are several varieties of cheese, produced in several different parts of the worlds. It is also true that there are several varieties of hybrids, issued in several countries. Credit Suisse hybrids are analogous to Emmental cheese. Like CS, Emmental is also Swiss. Emmental, is also renowned for its holes, referred to by cheesemakers as eyes. This is apt for our analysis and analogy, because the contractual terms of Credit Suisse’s hybrids also had holes. Credit Suisse’s hybrids had holes because its conditions had no mechanism for conversion to equity in the event of non-viability. In essence, non-viability is the subjective point where a bank or regulator determines that it has failed. Not all hybrids are created equal. In Australia, we have several different cheeses, my favourite is King Island Dairy’s smoked cheddar. Despite some not realising, we also have a number of different hybrids. The most obvious difference is the Issuer. The Big Five (ANZ/AN3, CBA, NAB, MBL/MQG, WBC) are the most frequent issuers, additionally, we have insurers (IAG, SUN, CGF), regional banks (BEN, BOQ) and other financial institutions (AMP, MYS, Members Equity, Police and Nurses Limited). Like cheese, we also have some imported varieties from France (BNP ParibasSociété General) and Switzerland (UBS). Some may be surprised to know that there are differences beyond that of just the line and Issuer in domestic hybrids. We highlight a few idiosyncratic examples with varying levels of materiality: New hybrids (post COVID) typically contain multiple call dates. This provides protection to investors which was manifested due to the non-call event of CGFPA. The protection is that when market conditions prevent a refinancing or redemption, there is another window of maturity through cash at par that precedes mandatory conversion—noting that CGFPA was mandatorily converted, but merely $28 million of $345 million remained outstanding at the time of conversion. CBA hybrids do not have the option to convert on optional call dates. It only has the option to redeem or resell for cash consideration. This is our preferred structure for Big Four hybrids. For hybrids issued by smaller banks, where solvency is less sound, conversion provides another needed option to allow Noteholders to be made whole. Insurance hybrids do not contain capital triggers, instead they only have non-viability triggers. MQG hybrids do not contain capital triggers but MBL hybrids do. Member’s Equity capital notes also do not have capital triggers. Member’s Equity is now owned by BOQ but at the time of issuances, it was unlisted and therefore has no provision for conversion. As a mutual, Police and Nurses Limited cannot convert its hybrids into equity, instead, it can convert into mutual capital instruments (MCI)—AYUPA is an example of an MCI. So, there are a number of different local cheeses, with varying flavours. What is common between all Australian ADI-issued hybrids, is that they are made within the framework and explicit approval of APRA, our long-bashed regulator that is criticised for dampening equity returns. It is not nearly often supported enough for its protection of creditors’ interests, be it retail depositors, hybrid-holders, or bond-holders. This commonality makes Australian hybrids look like Bega tasty cheese, a renowned block of cheese, infamous for its versatility as seen in the much adored ham and cheese sandwich, or even the more daring grated cheese on Vegemite toast. The trait that we highlight is the solid, dense and hole-less nature (or blind in cheesemaker terms). Whereas CS’s Emmental cheese had holes, three big ones specifically: the first was no ability to convert to equity and the second was FINMA, the Swiss Financial Regulator, electing to treat hybrid holders as subordinate to equity. Whilst there is not a clear way to provide for this in the documentation, we would argue policy on the fly would have been a smarter outcome—as the cost of capital for Swiss banks will have significantly increased for years to come off the back of this precedent. The third, mildly offsets point two, which is that although the point of non-viability had been reached, other bail-out bonds (Tier 2 bonds / HoldCo bonds) were not written off to absorb losses. Instead, these are still currently repayable at face value, with UBS now the credit counterparty. The niche third hole here is that bail-in was not consistently applied at the point of non-viability.

Read what you buy. 

Credit Suisse’s AT1 hybrid documentation clearly stated that conversion was not an option. Whilst we sympathise with perception with respect to priority of claims, a deeper reading by more investors may have recognised in this situation, where the notes could potentially be junior to equity. The most recently issued CS hybrid (Jun-22) came with a coupon of 9.75%. This is ironic given CS’s 2025 targets, announced in October 2022, was for a Group return on tangible equity of ~6%. This is lower than the coupon on the hybrids. Pricing talks. It is also notable that in June last year, CS called its final hybrid that contained conversion mechanisms. In other words, lawyers, bankers, and undoubtedly buyers of hybrids knew of this change upon primary issuance. On secondary trading, between counterparties of varying sophistication and depths of due diligence, these nuances may have been overlooked. This is the first time we have seen the statutory trigger exercised under the non-viability framework. In effect, the Swiss Regulator has exercised its discretion to write these hybrids to zero. This subjective judgement makes hybrids hard to value. It is the exact reason why we strongly advocate for expert advice or management when investing in this asset class. What makes our local market different to that of CS, is that our cheese is blind. There are no holes in the strength of our local hybrid documentation, regulation, and banking system. Whilst higher interest rates, falling housing prices and weaker financial conditions may challenge our local banking system, and financial hybrids may sell-off, or even in the future be bail-ed in, the critical takeaway is that there is not a scenario locally where we could see local hybrid holders treated the way CS hybrid holders have been treated in terms of its subordination to common equity. Notably overnight, the Bank of England released a statement on UK creditor hierarchy in an attempt to provide greater certainty to the UK hybrid market. Stating that “The UK’s bank resolution framework has a clear statutory order in which shareholders and creditors would bear losses in a resolution or insolvency scenario.” And “AT1 instruments rank ahead of CET1 and behind T2 in the hierarchy. Holders of such instruments should expect to be exposed to losses in resolution or insolvency in the order of their positions in this hierarchy”. In cheese terms, this announcement is a Red Leicester. British, strong in flavour and hole-less. We would welcome APRA providing a similar statement for market confidence and clarity. This CS resolution and treatment of hybrid holders has induced some local selling pressure on AT1s. Selling pressures on financials equity and bonds makes sense currently given the uncertainty. Precluding this, we have expected margin widening in ASX AT1s in order to see pricing that is more reflective of alternative bank capital stack bonds (covered/Tier 2/senior). Selling beyond those levels could provide an opportunity—especially contextualised against how jerk-like this AT1 market as can be (see March 2020) when credit spreads on our index measures hit 10% for a day.   Charlie Callan, CFA is an associate director at BondAdviser Any general advice has been prepared by BondAdviser Pty Ltd (ABN 31 164 148 467 AFSL 456783) without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG) for more information at www.bondadviser.com.au/important-information/. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser.

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