Tag: additional Tier 1 (AT1) capital

Convertible or not: making sense of stresses in AT1 bonds market

Mahmoud Fatouh and Ioana Neamțu

Similar to the Deutsche Bank’s episode in 2016 and the Covid stress in 2020, AT1 spreads over subordinated debt rose rapidly and sharply following the Credit Swiss rescue deal. Beyond these three cases, AT1 spreads have been stable. In this post, we focus on conversion risk of AT1 bonds (also known as contingent convertible, CoCo, bonds) to explain the sharp rise in AT1 spreads in these three cases. Conversion risk is the main additional risk of AT1 bonds, compared to subordinated debt. It arises from the potential wealth transfer from AT1 bondholders to existing shareholders when AT1 conversion is triggered, conditional on the solvency of the issuer. We show that, in normal times, investors believe conversion risk is very low, but major events can change this significantly, largely due to higher uncertainty.

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CoCo bonds and the risk appetite of banks: sweet or sour relationship

Mahmoud Fatouh and Ioana Neamțu

Since 2009, contingent convertible (CoCo) bonds have become a popular instrument European banks use to partially meet their capital requirements. CoCo bonds have a loss-absorption mechanism (LAM). When LAM is triggered, the bonds convert to equity capital or have their principal written down, providing more loss-absorbing capacity while a bank is still a going concern. The existing literature argues these bonds could increase risk-taking if shareholders gain at the expense of CoCo holders when the trigger is hit. In our two papers, we assess this argument theoretically and empirically. We show that the risk-taking implications of CoCo bonds rely on the direction and the size of the wealth transfer between shareholders and CoCo holders when LAM is triggered.

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