Optimal terms of contingent capital, incentive effects, and capital structure dynamics

Abstract

Contingent Convertible Bonds (CoCos) with conversion ratios that dilute issuer's shareholders generate incentives to preemptively raise equity capital to avoid triggering conversion. Our dynamic model provides an interior solution for the unique optimal conversion ratio and the capital structure policies that maximizes issuer's value net of deadweight costs. Preemptive recapitalization induced by moderately dilutive conversion terms leads to fewer defaults, lower borrowing rates, and higher debt capacity when compared to less dilutive terms. However, highly dilutive conversion ratios do not always enhance efficiency because issuers facing very high dilution risk recapitalize too frequently, generating excessive adjustment costs. Conversely, if CoCo's principal is written-down at the conversion without diluting shareholders, then the issuer will have perverse incentives to destroy a portion of its capital (“burn money”) to force conversion and generate windfall gains for shareholders.