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

In the aftermath of Credit Suisse's takeover by UBS, many investors lost out.

But one group felt particularly left behind: AT1 bond holders, who saw their 16 billion Swiss francs ($17 billion) worth of assets wiped out.

AT1 bonds would be written to zero as part of the deal between Credit Suisse and UBS, Swiss regulator FINMA said on Sunday. The move was somewhat unusual, prompting investors to threaten legal action and other financial authorities across Europe to distance themselves from FINMA.

But what are AT1 bonds, why do they matter and what happens next?

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.

AT1 bonds date back to the aftermath of the 2008 financial crisis, when regulators tried to shift risk away from taxpayers and increase the capital financial institutions held to protect them against future crises.

At the time, regulators in Europe established frameworks that specify capital ratios, so the balance between assets such as equity investments, AT1s and other, more senior debt. This is also the order they are meant to be prioritized in, according to the framework.

In Credit Suisse's case, however, the investments of AT1 holders were written off, while common shareholders are set to receive a payout from the deal.

In a research note, Goldman Sachs credit strategists said this "can be interpreted as an effective subordination of AT1 bondholders to shareholders," making the move an unusual one.

These bonds offered higher yields than many comparable assets, in some cases yielding almost 10%, reflecting the inherent risk investors were taking. The Credit Suisse AT1 prospectus, seen by CNBC, does suggest shareholders may be prioritized over these bondholders — but specifically if the bank fails. But bondholders have questioned whether the bank should be deemed "failing" in the traditional sense — a matter that will likely end up in the courts.

Carl Weinberg, chief economist and managing director of High Frequency Economics, told CNBC's "Squawk Box Europe" on Tuesday that regulators are meant to protect depositors and the system worked the way it should.

"While I feel bad about all these CoCos and AT1s who are losing their money … this is what the system was designed to do," he said. "This is a perfect example of regulation."

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.

On Monday, Elisabeth Rudman, global head of financial institutions at DBRS Morningstar, told CNBC's "Squawk Box Europe" that risks also extended to AT1 bonds at other banks.

"There would be risks attached to the pricing and how investors, perhaps some investors reassess the yield they are looking for," she said.

In Credit Suisse's case, AT1 bond holders are now considering taking legal action, with preparations underway at law firms.