The Agency of CoCos: Why Contingent Convertible Bonds Aren't for Everyone

Abstract

Most regulators grant contingent convertible bonds (CoCos) the status of equity. Theory, however, suggests that CoCos can induce debt overhang, thereby, increasing the cost of issuing equity. First, we theoretically investigate how the extent of this debt overhang varies with bank characteristics. Our model predicts that riskier banks face higher debt overhang from CoCos. Our empirical analysis confirms that riskier banks are less likely to issue CoCos than their safer counterparts. Since under Basel III banks are expected to raise equity prior to CoCo conversion, riskier banks that anticipate future equity issuance are less likely to issue CoCos before.

Keywords: CoCos, Contingent Convertible Bonds, Bank Capital Structure, Debt Overhang, Basel III

JEL Classification: G01, G12, G24