Goldman Sachs sees the risk of “permanent destruction” in demand for AT1 bonds

NEW YORK, March 20 (Reuters) – The decision by Swiss authorities to wipe out Credit Suisse’s additional Tier 1 (AT1) bonds could reduce demand for this type of bond in the long term, a Goldman Sachs strategist said, but the risk of contagion across of the credit markets was limited due to the relative niche nature of the asset class.

About $17 billion worth of AT1 Credit Suisse bonds will be written down to zero on orders from the Swiss regulator as part of a rescue merger with UBS ( UBSG.S ). Under the deal, holders of Credit Suisse AT1 bonds will get nothing, while shareholders, who typically rank below bondholders in terms of who gets paid when a bank or company collapses, will receive $3.23 billion.

AT1 bonds issued by other European banks fell sharply on Monday as the treatment of Credit Suisse AT1 bondholders highlighted the risks of investing in this type of debt.

The selloff was a “knee-jerk reaction to an outcome that surprised a lot of people,” Lotfi Karoui, credit strategist at Goldman Sachs, told Reuters.

But, he added: “In the long term, we are a bit concerned about the potential permanent destruction of demand … I think investors will have to reassess what the risk reward looks like in these instruments, especially at times of increasing economic distress.”

AT1 bonds act as shock absorbers if a bank’s capital level falls below a certain threshold. They can be converted to equity or written off.

European regulators tried to halt the AT1 market on Monday, saying owners of this type of debt would only suffer losses after shareholders are wiped out – unlike what happened at Credit Suisse. Meanwhile, law firm Quinn Emanuel Urquhart & Sullivan said it was talking to a number of Credit Suisse AT1 holders about possible legal action.

For Karoui, the risk that a reassessment of the risk of these types of securities could affect the performance of the broader credit market remained limited due to the size of the AT1 market and its investors.

He said AT1 bonds, excluding the Credit Suisse bonds, accounted for about $100 billion in the dollar market and just over $70 billion in the euro market, against more than $10 trillion of US-European investment-grade bonds.

“I would look at it as a small niche asset class … I don’t think there is overlap between the two investor bases,” he said.

Reporting by Davide Barbuscia and Saeed Azhar; Editing by Cynthia Osterman

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