Contingent convertible bond

A contingent convertible bond (CoCo), also known as an enhanced capital note (ECN)^[1] is a fixed-income instrument that is convertible into equity if a pre-specified trigger event occurs.^[2] The concept of CoCo has been particularly discussed in the context of crisis management in the banking industry.^[3] It has been also emerging as an alternative way for keeping solvency in the insurance industry.^[4]

Concept

The concept was first invented and proposed in the Harvard Law Review in 1991, following the junk bond crisis of the late 1980s.^[5] Many years later, others copied the idea as a solution for the banking industry following the great Financial Crisis of 2007-08.

The trigger and the conversion rate

A contingent convertible bond is defined with two elements: the trigger and the conversion rate. While the trigger is the pre-specified event causing the conversion process, the conversion rate is the actual rate at which debt is swapped for equity.^[6] The trigger, which can be bank specific, systemic, or dual, has to be defined in a way ensuring automatic and inviolable conversion.^[7][8] A possibility of a dynamic sequence exists—conversion occurs at different pre-specified thresholds of the trigger event.^[9] Since the trigger can be subject to accounting or market manipulation, a commonly used measure has been the market’s measure of bank’s solvency.^[10] The design of the trigger and the conversion rate are critical in the instrument’s effectiveness.^[11]

Forms

Contingent convertible bonds can take a variety of different forms such as a standby loan, a catastrophe bond, a surplus note, or a call option enhanced reverse convertible.^[12][13]

Advantages and criticism

In the context of crisis management, contingent convertible bonds have been particularly acknowledged for their potential to prevent systematic collapse of important financial institutions.^[14] If the conversion occurs promptly, a bankruptcy can be entirely prevented due to quick injection of capital which would be impossible to be obtained otherwise, either because of the market or the so-called recapitalization gridlock.^[15] In addition, due to its debt nature, a contingent convertible bond constitutes a tax shield before conversion. Hence, as compared to common equity, the cost of capital and, consequently, the cost of maintaining a risk absorbing facility are lower. In case the trigger event occurs, conversion of debt into equity drives down company’s leverage.^[16][17]

Also, contingent debt is said to have the potential to control the principal-agent problem in a two way manner—engaging both the shareholders and the managers. The greater market discipline and more stringent corporate governance are exercised as a result of shareholders’ direct risk of stock dilution in case conversion was triggered. An argument has been made that making managers’ bonuses in a form of contingent convertible debt instruments could reduce their behavior of excessive risk taking caused by their striving to provide investors with the desired return on equity.^[18]

On the other hand, contingent capital in a form of convertible bonds remains a largely untested instrument causing fears as to its effects especially during periods of high market volatility and uncertainty.^[19] The appropriate specification of the trigger and the conversion rate is critical to the instrument’s effectiveness. Some argue that conversion could produce negative signaling effects leading to potential financial contagion and price manipulation.^[20] Lastly, the instrument's marketability remains doubtful.^[21]

See also

• Risk management
• Capital structure
• Financial crisis of 2007-08

References

1. Fixed Income Investments
2. Pazarbasioglu et al. (2011), p. 4
3. Albul, Jaffee & Tchistyi (2010), p. 4
4. Harrington & Niehaus (2004)
5. "Distress-Contingent Convertible Bonds: A Proposed Solution to the Excess Debt Problem". Harvard Law Review 104 (8): 1857–1877. 1991-01-01. doi:10.2307/1341621.
6. Albul, Jaffee & Tchistyi (2010), p. 3
7. Albul, Jaffee & Tchistyi (2010), p. 3
8. Pazarbasioglu et al. (2011), p. 24
9. Albul, Jaffee & Tchistyi (2010), p. 4
10. Albul, Jaffee & Tchistyi (2010), p. 3
11. Pazarbasioglu et al. (2011), p. 4
12. http://www.businessdictionary.com/definition/contingent-capital.html. Retrieved on January 17, 2014
13. Pennacchi, Vermaelen & Wolff (2011)
14. Albul, Jaffee & Tchistyi (2010), p. 2
15. Duffie, 2010 as cited in Pazarbasioglu et al. (2011), p. 7
16. Flannery (2002)
17. Raviv (2004)
18. Pazarbasioglu et al. (2011), pp. 7–8
19. Pazarbasioglu et al. (2011), pp. 6–8
20. Sundaresan and Wang, 2010; Goodhart, 2010) as cited in Pazarbasioglu et al. (2011), p. 6
21. Pazarbasioglu et al. (2011), p. 6

Literature

• Albul, Boris; Jaffee, Dwight M.; Tchistyi, Alexei (2010). Contingent convertible bonds and capital structure decisions (PDF).
• Flannery, Mark J. (2010). Stabilizing large financial institutions with contingent capital certificates. CAREFIN Research Paper 04. doi:10.2139/ssrn.1485689.
• Flannery, Mark J. (2002). "No pain, no gain? Effecting market discipline via ‘reverse convertible debentures". In Hall S. Scott. Capital Adequacy Beyond Basel: Banking Securities and Insurance. New York: Oxford University Press. pp. 171–196. ISBN 978-0-19-516971-3.
• Pazarbasioglu, Ceyla; Zhou, Jian-Ping; Le Leslé, Vanessa; Moore, Michael (2011). Contingent capital: Economic rationale and design features.
• Pennacchi, George; Vermaelen, Theo; Wolff, Christian C. P. (2011). Contingent capital: the case for COERCs.
• Raviv, Alon (2004). Bank Stability and Market Discipline: Debt-for-Equity Swap versus Subordinated Notes. Mimeo. Brandeis University.