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, reducing the bank’s incentive to issue fresh equity. In this paper, we examine the debt overhang problem of CoCos. First, we theoretically investigate how the extent of this debt overhang varies with bank characteristics. Our model predicts that banks with higher asset volatility face higher debt overhang from CoCos. Next, we analyze a comprehensive database of CoCo issuance. We find that banks with higher asset volatility are less likely to issue CoCos than those with safer assets. Since under the current regulatory framework of Basel III banks are expected to raise equity prior to CoCo conversion, riskier banks that anticipate 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