Everyone’s talking about Credit Suisse’s risky bonds. Here’s what they are and why they matter

AT1 bonds is short for additional tier-one bonds. In short, they are bank bonds that are considered a relatively risky form of junior debt, therefore coming with a higher yield and are often bought by institutional investors.

Sometimes they are also referred to as contingent convertibles or “CoCos.” The name comes from the ability to convert them into either equity or write them off, so cut their value to zero — but only in specific scenarios.

This is often related to the capital ratio of the bank that issued the bonds. If it declines below a certain level, for example, the contingency plan of investors converting their holdings becomes an option.

One of the key attributes of AT1 bonds is that they are designed to absorb losses. This happens automatically when the capital ratio falls below the previously agreed threshold and AT1s are converted to equity.

Bigger banks often however have a substantial buffer thanks to the capital ratio requirements, so this outcome is rare — Credit Suisse’s takeover was the first big test for AT1s.

This is also where one of the main risks comes in — if the mechanism is triggered, bondholders can lose their investment entirely or end up with equity holdings in a weakened bank.

Another factor that contributes to elevated risk is the power regulators have, who can, for example, limit payments on the annual interest rate of bonds, including with AT1 bonds.

Finally, AT1 bonds are callable rather than maturing at a specific point. Usually, banks call and reissue them during a specific time period, but if they don’t investors are stuck with them for longer.

Various EU regulators have distanced themselves from FINMA’s decision to wipe out the value of Credit Suisse’s AT1 bond holders. Switzerland is not part of the European Union and so is not subject to the bloc’s regulations. But some damage may have already been done and could impact the broader mood of investors.

“European regulators and central bankers are now attempting to restore confidence in the AT1 bond market, which now poses a major threat to any extension of the recovery in investor sentiment in the region,” ING strategists said in a note published Tuesday.