UBS issues $3.5bn Dory bond

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Less than eight months after Swiss authorities wiped out $17bn of Credit Suisse’s AT1 bonds, UBS — which made a $29bn profit by buying Credit Suisse for $3bn — was able to issue a new AT1 structure.

Let’s call this a Dory bond, named after the character from Finding Nemo who struggles with short term memory loss. The $3.5bn deal reportedly attracted north of $35bn of orders, more than twice the amount of AT1 securities destroyed by the Swiss authorities. Not bad for an asset class that was supposed to be dead after the controversial decision!

As Appaloosa’s David Tepper told the FT after the CS AT1 were nuked:

“If this is left to stand, how can you trust any debt security issued in Switzerland, or for that matter wider Europe, if governments can just change laws after the fact? Contracts are made to be honoured.”

Or Davide Serra of Algebris:

“They’ve changed the law and they have basically stolen $16bn of bonds . . . This has been a big policy mistake, [and] they will regret it. [ . . . ] Switzerland will be the new pariah in this [loss-absorbing bond market]. They asked for it, they will have it.”

How can one explain such an extraordinary volte-face?

Well, first, the asset class was never actually going to die. Even after factoring in the Credit Suisse wipeout, AT1 bondholders have on average in aggregate made more money than senior bondholders over the past decade, simply because the coupons they are paid to compensate them for the risks of precisely these nasty scenarios are much bigger.

AT1s did not die very much in that the same way senior bonds didn’t die after the Banco Espirito Santo resolution and subsequent Novo Banco shenanigans. Likewise, the Tier 2 market did not die after the Banco Popular resolution and the 1,000-plus lawsuits that followed. Credit losses are part of the credit market.

Proposed buyer “boycotts” usually suffer the same demise as doomsday predictions for an entire asset class: they slowly fall into oblivion. I cannot say for sure, but I would be very surprised if Pimco is boycotting Spanish government bonds (ed note: they are not).

Nonetheless, shouldn’t investors be more careful before putting in $35bn of orders for a new AT1 from a Swiss bank?

First of all, you shouldn’t trust that number. Demand was strong — UBS was able to reduce the coupon on offer, after all — but the overall nominal size of the order book is illusory.

The way the primary market operates is that when buyers identify bonds with a significant new issue premium, they put a much bigger order than they actually want to buy because they expect to be allocated a small share of their order. The new UBS AT1 were trading as high as 102 in the grey market so everyone upsized their orders — probably quite significantly — just for the one-day gain.  

Even if the number is not realistic, it still shows a great amount of demand for the new bonds, so the question remains. Which lessons should have been learned that investors have supposedly forgotten already?

That Switzerland is a ‘banana republic’? Sure, introducing a decree on a Sunday evening just to impose bondholder losses isn’t a great look, but let us be honest: are we entirely sure Italy, Spain, Portugal, Ireland or even France or Germany would never do that? Even the ECB famously swapped their Greek bonds into identical bonds but with different ISIN codes in 2012, just to escape the “burden sharing” transaction that they helped organise. People screamed then as well, but quickly moved on.

That Swiss banks are weak? Credit Suisse was clearly the weak link of European banking and some would call UBS’s opportunistic swoop for it the deal of the century. There’s a reason they earned $29bn of (admittedly purely accounting) profit on the deal. It’s likely that UBS will emerge as a stronger credit as a result, despite the split views from the rating agencies. It’s also unlikely that the Swiss authorities will engage in a similar “bailout” any time soon, considering the political backlash they faced . . . and the lack of any Swiss buyer able to swallow a bank the size of the new UBS!

As the “read the prospectus” crowd likes to remind us, permanent writedown clauses are ugly? Two things to note here. Prospectus clauses are important but not that important in AT1 bonds: the overriding principle of the resolution framework agreed at the G20 level is that resolution authorities should have great leeway and extraordinary powers to manage banking crises.

Practice has shown that, ultimately, bondholders of the same failing bank have often (but not always! So do read the prospectus!) suffered the same fate, whatever the fine print of the terms and conditions.

It’s also worth pointing out that UBS did listen to investor feedback and introduced a clause allowing for equity conversion of the bonds in case of viability concerns, instead of permanent writedown. This clause will be introduced once the necessary changes to the company bylaws have been adopted (though NB, there might be some issues with US investors . . . )

To summarise all this a bit more succinctly, let’s introduce the Dory Efficient Markets Hypothesis: it is perfectly normal for markets not to look in the rear-view mirror. Investors trying to maximise the risk-return profiles should set aside any grudges and make trading decisions accordingly.

If that bond is good value, just buy it. It’s as simple as that.