Abstract
We make the case for sovereigns to issue contingent convertible bonds as a means to forestall debt crises. These instruments contractually stipulate payment standstill, contingent on a sovereign’s credit default swap spread breaching a distress threshold. This is a financial innovation solution to the lack of sovereign debt restructuring mechanisms, limiting ex ante the likelihood of debt crises and imposing ex post risk sharing between creditors and the debtor. The new instruments are contingent contracts addressing neglected risks in sovereign debt. Building on literature for contingent convertible debt for banks we address the design of sovereign contingent debt, including market discipline and sovereign incentives; market manipulation and multiple equilibria; errors of false alarms or missed crises. Then we develop a risk optimization model to incorporate contingent debt in the portfolio of instruments financing a sovereign. Using Greece as a case study we illustrate Pareto improvements in expected cost vs tail risk.
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