The Trishanku Bonds: Suspended Between Debt and Equity

The Supreme Court’s recent decision to reserve judgment in the Yes Bank AT1 bond write-down case may ultimately become far more significant than a dispute over ₹84.15 billion of erased securities. The Union government itself reportedly warned the court that the ruling could have implications for India’s nearly ₹1 trillion AT1 bond market.

That warning is revealing.

Because the real issue before the court is not merely whether the write-down during Yes Bank’s 2020 rescue was legally valid. Look at the collapse of Credit Suisse and the infamous wipeout of roughly $17 billion worth of AT1 securities. The deeper question is whether modern regulators have quietly created a financial instrument whose legal identity changes depending on the stage of the crisis.

Australia appears to have already reached its own conclusion. The Australian Prudential Regulation Authority decided that perhaps the problem with these instruments was not merely disclosure or pricing, but the instrument itself. APRA announced that Additional Tier-1 bonds would gradually cease to qualify as regulatory capital beginning 2027, with complete phase-out by 2032, citing their complexity and heavy retail participation.

And yet, in a beautifully ironic twist, global banks like Barclays, UBS and BNP Paribas have already begun stepping into the Australian dollar market to satisfy investor appetite for these very same instruments.

The casino, it seems, remains open even after the fire alarm.

That, perhaps, captures the essence of CoCo bonds — contingent convertible securities, the fashionable global name for AT1s.

Like Trishanku from mythology, these instruments exist in permanent suspension ˍ— neither fully debt nor fully equity, neither fully protected nor fully sacrificial. Their identity depends less on financial logic and more on regulatory convenience during distress.

The Swiss banking crisis exposed this contradiction brutally. AT1 bondholders at Credit Suisse were wiped out while shareholders still received residual value through the rescue arrangement. One of the oldest assumptions in capitalism that equity absorbs losses before debt, suddenly became negotiable.

And that is the first dilemma of CoCo bonds.

Regulators marketed them as “bail-in” instruments designed to spare taxpayers from rescuing banks. In theory, investors knowingly absorb losses during distress. But in practice, authorities often engineer outcomes resembling selective bailouts elsewhere in the capital structure. Depositors remain protected. Senior creditors survive. Equity holders sometimes retain value. Yet AT1 investors become the designated sacrificial layer. Who says financial regulators cannot innovate!!

This creates a peculiar hybrid regime where capitalism and state intervention coexist opportunistically. In normal times, the instrument behaves like yield-generating debt. During crises, it transforms into quasi-equity meant to absorb politically inconvenient losses.

It is neither pure bail-in nor pure bailout.

It is regulatory shape-shifting.

The second dilemma is more technical but equally destabilising.

AT1 bonds are perpetual securities with embedded call options. Under stable conditions, markets usually assume banks will redeem them at the first available call date, allowing valuation on a “yield-to-call” basis. But after Credit Suisse, that assumption weakened globally.

Investors were suddenly forced to ask: should these instruments instead be valued as perpetuities?

The distinction is enormous.

Valuing them to perpetuity can sharply depress prices because uncertainty extends indefinitely. For mutual funds and debt portfolios holding AT1 paper, this creates severe mark-to-market instability. Instruments once marketed as sophisticated income products begin behaving like volatile hybrids vulnerable not only to credit risk, but also to regulatory interpretation and extension risk.

Even the mathematics of valuation becomes hostage to policy discretion.

That is what makes CoCo bonds such extraordinary inventions. They do not merely blur the line between debt and equity. They blur the line between contractual finance and administrative improvisation.

During prosperity, banks enjoy cheaper capital without excessive shareholder dilution. Regulators boast of stronger balance sheets. Investors collect attractive coupons in a low-yield world.

But when distress emerges, the instrument mutates.

Suddenly investors are reminded they were never conventional creditors at all. They were “loss absorbers,” contingent participants in systemic rescue architecture. The hierarchy changes. The interpretation changes. Sometimes even the valuation framework changes.

One must admire the creativity.

For centuries, finance operated on a relatively comprehensible principle: equity takes first loss because equity enjoys first upside. Debt ranks above because it sacrifices upside for contractual certainty.

AT1 bonds demolished that simplicity by creating a security whose legal and economic identity changes with circumstances. Schrödinger would have appreciated the structure.

The irony, of course, is that all this is justified in the name of financial stability.

Yet stability built upon interpretational flexibility carries its own dangers. Markets function not merely because contracts exist, but because participants trust how contracts will behave under stress. Once precedence becomes negotiable, capitalism slowly migrates from rules toward discretion.

And perhaps that is the true legacy of the CoCo era.

Not merely that banks invented contingent capital.

But that regulators normalised contingent legality.