CoCo Bonds, Conversion Prices and Risk Shifting Incentives - How Does the Conversion Ratio Affect Management's Behaviour?
28 Pages Posted: 20 Apr 2013
Date Written: May 2013
The aim of this paper is to analyze risk shifting incentives for managers and shareholders of the financial institution issuing a CoCo bond. We assess the role of the conversion price settlement in enhancing both shareholders’ and management's discipline. Three recent contingent reverse convertible deals are analyzed, with the intention of showing how shareholder conversion returns are linked to the conversion ratio. The findings demonstrate that, in the case of an ingoing or ongoing crisis, a poor settlement of the conversion ratio could exacerbate both debt overhang and risk shifting issues. This will end in discouraging bank management from issuing new equity and from investing in low risk assets. We argue that a contingent bond triggered on Basel III capital requirement ratios and having a significantly discounted conversion price reduces risk shifting incentives. Moreover, we illustrate how the unexpected wealth transfers between CoCo bondholders and shareholders tends to zero when the bond face value is higher than the current stock market price and there is a concentration of bond subscribers. Accordingly, regulators should consider and oversee not only the conversion trigger but also all the other features of a contingent capital security, especially the conversion ratio.
Keywords: contingent reverse convertibles, CoCo bond, risk shifting incentives, bank stability, conversion ratio
JEL Classification: G21, G13, G28, G32
Suggested Citation: Suggested Citation