Investors are rationally crazy to buy UBS's Cocos

These bonds, known as Additional Tier One capital, or colloquially as CoCos, are complex and risky

It is easy to point and chuckle at investors who pile back into an asset class that’s just handed them brutal losses, but there are sound reasons behind the roaring success of this week’s US$3.5 billion junior bond sales from UBS Group AG.

Even investors who got burned when the Swiss government forced Credit Suisse Group AG to write off US$17 billion of such bonds in March ahead of its rescue by UBS have bought into the new deal. That sounds like the definition of monetary masochism, but there’s a string of differences in the bonds and in markets that helped the two-part UBS trade attract US$36 billion in orders.

These bonds, known as Additional Tier One capital, or colloquially as CoCos, are complex and risky: When a bank gets in serious trouble, the chances are investors will lose everything. But banks and regulators will spend a lot of time and energy trying to ensure big banks don’t fail and the yield on these bonds is generous enough to attract generalist as well as specialist money.

For UBS, pricing, of course, was one factor behind the success. It sold two deals Wednesday, both perpetual bonds — a necessary qualification to count as loss-absorbing capital — but with the option for early repayment. One can be called after five years, and the other after 10 years, both yielding 9.25% having begun the sales process at 10% and above. Even after this cut, investors saw the terms as generous next to BNP Paribas SA deals that yield less than 9%, for example.

By Thursday, both of the UBS issues were up in price terms by 1% to 2%. Still, some thought UBS might have been more generous to investors still smarting from their Credit Suisse losses. “If you were expecting a ‘We are sorry’ trade from UBS, you didn’t get that,” said Filippo Alloatti, head of financial credits at Federated Hermes.

Investors have been waiting for these bonds for months, however, and the market has been starved of much new supply since the turmoil that engulfed Credit Suisse. Several banks have called junior bonds without immediately refinancing this year, which has meant a net reduction in the amount available for investors to buy. Some specialist funds have seen outflows as investors got spooked, but wider demand for junior bank debt has remained healthy.

Also in its favour, UBS just reported third-quarter results that showed it is making good headway on integrating Credit Suisse and getting shareholders excited about its ability to resume stock buybacks sooner than expected. There are risks in the merger work it has to do and the legacy of litigation against Credit Suisse that it now has to settle. But it’s seen as a strong bank that will be a big issuer of junior bonds, which should help them to be more readily tradeable than smaller banks’ securities. 

But the key difference between the new UBS bonds and all previous Swiss CoCos is in what happens if the bank should ever need them to soak up losses. These deals will be allowed to convert into equity if UBS hits disaster, whereas other Swiss CoCos were designed to be written off leaving investors with nothing. This is what happened in Credit Suisse’s collapse even though its shareholders got some — admittedly tiny — compensation in UBS shares. Lawsuits ensued.

Still, seasoned investors know that this change won’t make much difference if the rubber ever hits the road. This convertibility was important for marketing the bonds — the old permanent writedown feature was never going to sell. But if a bank like UBS ever gets to the point where its AT1s are converted into stock, it will be happening as part of a deeply distressed capital raise or takeover that will mean the value of what bond investors are left with is so deeply diluted that this compensation will be token at best.

It satisfies the principle of the thing: Bondholders shouldn’t ever end up worse off than shareholders again. But really that’s going to be cold comfort if things go badly. Maybe these investors are still crazy after all. 

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