Contingent Convertible Research Articles

Mind the Conversion Risk: A Theoretical Assessment of Contingent Convertible Bonds

We develop a theoretical model to assess the merits of principal-write down contingent convertible (CoCo) bonds. The conversion risk is the key feature of CoCo bonds. Because of this conversion risk, CoCo bonds are hard to price and an equilibrium price does not necessarily exist. In our model, for such a price to exist, the bank needs to hold a minimum amount of equity and/or the expected return associated with its asset portfolio needs to be large enough. When an equilibrium price exists, it is a decreasing function in the amount of equity held by the bank. Well-capitalized banks can thus issue CoCo bonds at a lower price than least-capitalized banks. This is the reason why CoCo bonds are to be thought of more as a complement to equity than as a substitute. In addition, because of the conversion risk, self-fulfilling panics may occur in the CoCo bonds' market. We indeed define a game between CoCo bonds' holders and the Central Bank that allows us to exhibit situations where a panic occurs in the CoCo bonds' market. Using the global game technique, we show that the probability of crisis can be expressed as a function of the return associated with the asset portfolio of the bank. The probability of crisis is shown to be sensitive to the precision of the information available to CoCo bonds' holders. Taken together, our results call for cautiousness when assessing the relevance of regulatory requirements in CoCo bonds, especially concerning their systemic impact.

The Default Contagion of Contingent Convertible Bonds in Financial Network

This paper investigates the impact of Contingent Convertible (CoCo) bonds on systemic risk using Eisenberg-Noe’s financial network method, where the network is linked by debt relationship. The default contagion and loss amplification due to network linkage measure the systemic risk, from which we can ascertain the potential impact of CoCo bonds on systemic risk. Results show that CoCo bonds enhance the spillover effect of issuer’s default; in the meanwhile, sufficient CoCo bonds partly offset the impact of default contagion from other institutions. In addition, CoCo bonds enhance the amplification effect of loss due to network linkage, but the amplification effect diminishes after considering the bankruptcy cost. Finally, the numerical test is given to provide some insight into how the issuance of write-down (WD) bonds have influences on commercial banks in China.

Addressing Systemic Risk Using Contingent Convertible Debt — A Network Analysis

We construct a balance sheet based network model to study the interconnectedness of US banking system. After a simulation analysis of the buffer effect of contingent convertible (CoCo) debt in controlling contagion in the banking network under a theoretically motivated model, we use 13-F filings made to the US Securities and Exchange Commission (SEC) to calibrate the theoretical model. Our results demonstrate that CoCo debt conversion significantly reduces the average number of bank failures, decreases the Delta-CoVaR of the banking system, and thus, mitigates systemic risk. While CoCo debt with dual-trigger is not so efficient as a single trigger design in reducing individual bank failures, the former is more effective at protecting the surviving banks, which leads to improved stability from the perspective of the banking system. Two-tranche CoCo debt can combine the benefits of single trigger and dual trigger CoCo debt. We claim that the different designs of CoCo triggers result in trade-offs for addressing systemic risk, which may be evaluated in a network model developed in this work.

PRICING SOVEREIGN CONTINGENT CONVERTIBLE DEBT

We develop a pricing model for Sovereign Contingent Convertible bonds (S-CoCo) with payment standstills triggered by a sovereign’s Credit Default Swap (CDS) spread. We model CDS spread regime switching, which is prevalent during crises, as a hidden Markov process, coupled with a mean-reverting stochastic process of spread levels under fixed regimes, in order to obtain S-CoCo prices through simulation. The paper uses the pricing model in a Longstaff–Schwartz American option pricing framework to compute future state contingent S-CoCo prices for risk management. Dual trigger pricing is also discussed using the idiosyncratic CDS spread for the sovereign debt together with a broad market index. Numerical results are reported using S-CoCo designs for Greece, Italy and Germany with both the pricing and contingent pricing models.

Optimal Security Design under Asymmetric Information and Profit Manipulation

We consider a model of external financing under ex ante asymmetric information and profit manipulation (non verifability). Contrary to conventional wisdom, the optimal contract is not standard debt, and it is not monotonic. Instead, it resembles a contingent convertible (CoCo) bond. In particular: (i) if the profit manipulation and/or adverse selection are not severe, there exists a unique separating equilibrium in CoCos; (ii) in the intermediate region, if the distribution of earnings is unbounded above there exists a unique pooling equilibrium in CoCos, otherwise debt might be issued but it is never the unique equilibrium; (iii) finally, if profit manipulation is severe, there is no financing These findings suggest that the standard monotonicity constraint exogenously imposed in the security design literature must be reconsidered. Crucially, profit manipulation is part of the optimal contract, and non-monotonic, convertible securities mitigate the asymmetric information problem. We discuss milestone payments in venture capital as an application.

Contingent Convertible (CoCo) Bond Literature Review: Making Everything and Nothing Possible?

Contingent Convertible (CoCo) Bond Literature Review: Making Everything and Nothing Possible?

Contingent Convertibles with Stock Price Triggers: The Case of Perpetuities

Initial proposals for contingent convertibles (CoCos) envisioned that these bonds would convert to equity when the issuing bank’s stock price declined to a prespecified trigger. Subsequent research has claimed that doing so causes the stock price to have multiple equilibria or no equilibrium. We show that when CoCos are perpetuities, which characterizes most actual CoCos, a unique stock price equilibrium exists, except under unrealistic conditions. Unique equilibria occur when conversion favors or disfavors CoCo investors, when CoCos convert to equity or are written down, and when CoCos are callable. We also analyze a bank’s risk choices before and after conversion. Received November 29, 2016; editorial decision July 15, 2018 by Editor Itay Goldstein.

Raising bank loss absorption capacity through equity capital or bail-in debt

PurposeBased upon recent statements made by the European Shadow Financial Regulatory Committee, a group of well-known professors coming from ten European countries, during the period 2012-2017, this paper aims to analyze from a European perspective the adequacy and credibility of the proposed framework.Design/methodology/approachThis paper is a summary and interpretation of statements from the European Shadow Financial Regulatory Committee.FindingsThe authors argue that the credibility of the bail-in mechanism is likely to be limited. Because of this, unexpected losses may not be absorbed by unsecured debt holders. Therefore, there is still a need for relatively high equity capital buffers.Originality/valueThe issue of how to raise loss absorption capacity for banks is prominent on the international policy agenda. International regulators are aiming for a combination of equity capital, typically raised by issuing shares, retaining profits and issuing contingent convertible (CoCo) bonds and bail-in debt where unsecured creditors such as holders of subordinated and common bonds are supposed to take losses in case of a bankruptcy or restructuring of a bank.

How Do CoCo Bonds Impact a Bank's Shareholder Wealth?

Basel III has been agreed to strengthen banks’ capital. Raising additional capital in common equity is costly. Banks wonder whether capital can be raised less expensively. To this end, Contingent Convertible (CoCo) bonds have been designed to absorb banks’ losses in times of crisis. This paper examines the impact of Debt-to-Equity CoCo bonds on a bank’s capital structure. For the first time, leverage ratios based on non-risk-weighted-assets are used as equity conversion triggers instead of capital ratios based on risk-weighted-assets. We find that CoCo bonds generally increase shareholder wealth by reducing their bankruptcy risk, except when the dilution effect offsets this positive effect. We also highlight the importance of defining different parameters properly when designing CoCo bonds. When these parameters are appropriately chosen, CoCo bonds are able to fulfill their function as “going-concern” capital, while bank shareholders are capable of reconciling their financial interests with the regulators’ risk prevention objectives.

How do CoCo bonds impact a bank’s shareholder wealth?

The 2008 crisis highlighted the fragility of the banking system. To address this deficiency, the Basel committee agreed on the Basel III Accord to strengthen banks’ capital requirements. However, raising additional common equity funds is costly. Facedwith this problem, banks and regulators wonder whether capital can be raised lessexpensively. To this end, Contingent Convertible (CoCo) bonds have been designedto absorb banks’ losses in times of crisis. Might CoCo securities be an effective prevention and/or rescue solution? This article examines the impact of Debt-to-EquityCoCo bonds on a bank’s capital structure. For the first time, leverage ratios based onnon-risk-weighted-assets (NRWA) are used as equity conversion triggers instead oftraditional capital ratios based on risk-weighted-assets (RWA). We find that CoCobonds generally increase shareholder wealth by reducing their bankruptcy risk, except when the dilution effect offsets this positive effect. By boosting banks’ capacityto absorb losses while giving regulators more time to find a rescue solution, CoCobonds strengthen financial stability. We also highlight the importance of definingdifferent variables and parameters properly when designing CoCo bonds. Whenthese variables and parameters are appropriately chosen, CoCo bonds are able tofulfil their function as “going-concern” capital, while bank shareholders are capableof maximizing their wealth.

Reinforcing the Capital of a Bank with Two Tranches of Coco Bonds

Following the 2008 crisis, Basel III has imposed higher banking capital requirements. To comply with this, banks will have to issue new equity and/or sell some of their assets, which will put pressure on financial markets. To ease such pressure, banks and regulators are wondering whether capital might be raised in other forms such as Contingent Convertible (CoCo) bonds, which are basically bonds that can be converted into equity when triggered by a specified event. This article examines the capital structure of a bank financed by equity, traditional bonds, and two tranches of debt-to-equity CoCo bonds. The Junior Tranche aims to prevent risk when the bank is still in good health, while the Senior Tranche aims to rescue the bank when it is already in crisis. The choice of triggers is decisive to ensure that the two tranches of CoCo bonds fulfil their missions of prevention and rescue.

Contingent capital with repeated interconversion between debt‐ and equity‐like instruments

AbstractThis paper introduces a new form of contingent capital, contingent convertible securities (CCSs), which might repeatedly convert between debt‐ and equity‐like instruments depending on financial conditions. We derive explicit prices of corporate securities, assuming the cash flow is modeled as a geometric Brownian motion. We present an explicit value of the increased tax shields due to CCSs. We provide an explicit optimal capital structure when CCSs are issued and interestingly, the ratio of the optimal straight bond coupon to CCS coupon is constant and independent of the firm's financial conditions. All the conclusions hold true also for contingent convertibles.

Why Do Banks Issue Contingent Convertible Bonds?

This study investigates why banks issue Contingent Convertible Bonds (CoCos). We find that a bank’s systemic risk level is a possible reason for CoCo issuance. Contrary to the pecking order theory, earnings management practices play a lesser role, and there is no evidence of banks becoming riskier after issuing CoCos. However, we find systemically riskier banks are more likely to issue CoCos. Thus, riskier banks may be utilising CoCo loss absorption mechanisms to partially internalise the costs of future loan losses. If banks are issuing such instruments without regulatory prompting, then an issuance may signal the need to provide greater oversight. Conversely, if such issuances do result from regulatory prompting, then banks may be engaging in risk management strategies, minimising their cost of equity issuance.

Why Do Banks Issue Contingent Convertible Bonds?

Why Do Banks Issue Contingent Convertible Bonds?

The Agency of CoCo: Why Do Banks Issue Contingent Convertible Bonds?

Most regulators grant contingent convertible bonds (CoCos) the status of equity. The theory, however, suggests that these securities can distort incentives via inducing debt overhang and risk shifting. In this paper, we therefore theoretically model how the degree of this distortion varies with bank risk. Our model predicts that riskier banks face higher debt overhang from CoCos. Next, analyzing a comprehensive database of CoCo issuance in Europe, we empirically test the predictions of our model. We find that banks with lower risk are more likely to issue CoCos than their riskier counterparts. Since in the current regulatory framework of Basel III banks are expected to raise equity prior to CoCo conversion, future debt overhang makes CoCos an expensive source of capital. Thus, riskier banks will opt for equity issuance over CoCos.

NUMERICAL PRICING OF CoCo BONDS WITH PARISIAN TRIGGER FEATURE USING THE FORTET METHOD

Unlike conventional convertible bonds, contingent convertible (CoCo) bonds are converted into equity shares of the issuing bank subject to certain trigger mechanisms (accounting and/or regulatory trigger) when the issuing bank is under financial nonviable state. We consider pricing of these CoCo bonds using the contingent claims approach, where the state variables are the stock price and Tier 1 capital ratio. We use the Parisian feature to model the regulatory trigger where equity conversion is triggered when the capital ratio stays under the nonviable state consecutively for a certain period of time. The accounting trigger is modeled using the one-touch barrier feature associated with the capital ratio. The Parisian trigger feature adds one extra path dependent state variable in the pricing model of a CoCo bond. We design effective numerical algorithms for pricing the CoCo bonds using the extended Fortet method that avoid adding one extra state variable for the Parisian feature of regulatory trigger. Pricing properties of the CoCo bonds under both regulatory trigger and accounting trigger are explored.

Valuation and analysis of performance sensitive debt with contingent convertibility

We develop a new type of performance sensitive debt (PSD), called contingent convertible PSD (CPSD), which can be converted into equity in financial distress. We address the pricing of corporate securities and optimal capital structure including CPSD. Most of the results are given explicitly and numerical analyses are provided. The results explain that CPSD is a valuable security in increasing the value of tax shields while keeping default risk in a low level. The firm value is increased due to the issuance of CPSD. The risk-compensating feature of CPSD can alleviate the inefficiencies arising from debt overhang and asset substitution. On the contrary, if equity holders benefit from a conversion, the contingent convertibility will aggravate them. The inefficiencies decrease with the conversion ratio of CPSD.

ANALYTIC PRICING OF CoCo BONDS

We present a new model for pricing contingent convertible (CoCo) bonds which facilitates the calculation of equity, credit and interest rate risk sensitivities. We assume a lognormal equity process and a Hull–White (normal) short rate process for the conversion intensity with a downward jump in the equity price on conversion. We are able to derive an approximate solution in closed form based on the assumption that the conversion intensity volatility is asymptotically small. The simple first-order approximation is seen to be accurate for a wide range of market conditions, although particularly for longer maturities higher order terms in the asymptotic expansion may be needed.

Contingent Capital, Tail Risk, and Debt-Induced Collapse

We study the design and incentive effects of contingent convertible debt. With contingent convertibles, the endogenous bankruptcy boundary can be at either of two levels: one with lower default risk or one at which default precedes conversion. An increase in debt moves the firm from the first regime to the second, a phenomenon we call debt-induced collapse. Setting the conversion trigger sufficiently high avoids this hazard. Given this condition, we investigate the effect of contingent capital and debt maturity on optimal capital structure, debt overhang, and asset substitution. We calibrate the model to large banks during the financial crisis. Received April 10, 2015; editorial decision March 20, 2017 by Editor Leonid Kogan.

Convertible Debt Instruments in International Tax Law – Part 2

This two-part article contains an in-depth analysis of a variety of convertible debt instruments from the perspective of international tax law. Part 1, which was published in European Taxation 4 (2017), covered optional convertible instruments, mandatory and reverse convertibles, contingent convertibles, warrants and option loans and provided an overview of domestic law in a number of countries. Part 2 analyses the classification and treatment of the different types of convertible debt instruments from the perspective of EU corporate tax directives and tax treaties.