Goldman Sachs sees risk of 'permanent destruction' in demand for AT1 bonds

By Davide Barbuscia and Saeed Azhar

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

Some $17 billion worth of AT1 Credit Suisse bonds will be written down to zero on the orders of the Swiss regulator as part of a rescue merger with UBS. Under the deal, holders of Credit Suisse AT1 bonds will get nothing, while shareholders, who usually 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 sell-off was a "knee jerk reaction to an outcome that took a lot of people by surprise," Lotfi Karoui, chief credit strategist at Goldman Sachs, told Reuters.

But, he added: "In the long term, we are a little concerned about the potential permanent destruction in demand ... I do think that investors will have to re-assess how the risk-reward looks like in those instruments, particularly at times of rising financial distress."

AT1 bonds act as shock absorbers if a bank's capital levels fall below a certain threshold. They can be converted into equity or written off.

European regulators tried to stop the AT1 market rout on Monday saying owners of this type of debt would only suffer losses after shareholders have been 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 re-assessment of the risk of this type 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 ones, totalled about $100 billion in the dollar market and just over 70 billion in the euro market, against over $10 trillion of investment grade bonds between the U.S. and Europe.

"I would view it as a small, niche asset class ... I don't think there's overlap between the two investor bases," he said.

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