Optimal Capital and Debt Structures with Loss-Absorbing Debts

Abstract

We analyze a defaultable firm's optimal capital and debt structures when its debt includes senior straight bonds and either Contingent Convertible or Write-Down bonds. The firm's stakeholders bear a liquidity risk prior to the debt maturity and a solvency risk at maturity. Credit events and premature or terminal bankruptcy are triggered if the firm's asset value hits barriers that are endogenously obtained. The optimal capital structure and the optimal senior/loss-absorbing debt mix are jointly determined, in closed form, along with the optimal level of debt reduction in the case of Write-Down debt. The credit spread on the senior debt is shown to be considerably lower when the firm's capital structure also includes loss-absorbing bonds, for a given global leverage. The spreads on the loss-absorbing and senior debts predicted by the model are realistic for plausible values of the exogenous parameters.