Contingent convertible bonds for sovereign debt risk management
The Wharton Financial Institutions Center WP 15-13, in print Journal of Globalization and Development.
32 Pages Posted: 26 Nov 2015 Last revised: 20 Oct 2018
Date Written: November 1, 2015
We consider convertible bonds that contractually stipulate payment standstill, contingent on a market indicator of a sovereign's creditworthiness breaching a distress threshold. This financial innovation limits ex-ante the likelihood of debt crises and imposes ex-post risk sharing between creditors and the debtor. Drawing from literature on contingent contracts, neglected risks, and bank CoCo, we extend prevailing arguments in favor of sovereign CoCo (S-CoCo). We discuss issues relating to their design: which market trigger, market discipline and sovereign incentives, and errors of false alarms or missed crises, and provide supporting evidence with eurozone data and a simple simulation on the use of S-CoCo. We develop a risk management model using these instruments to trade off the expected cost for sovereign financing over a long horizon, with tail risk. The model shows how contingent bonds can improve a country's debt risk profile. Using Greece as a case study the model illustrates improvements in expected cost vs tail risk for the country when using contingent debt.
Keywords: Contingent debt, sovereign crises, CDS spreads, debt restructuring, pricing, risk management, banking
JEL Classification: C61, C63, D61,E3, E47, E62, F34, G21, G38, H63
Suggested Citation: Suggested Citation