Himmelberg and Tsyplakov (2012) analyze, in a jump-diffusion setting, the ex ante impact of the chosen type of loss-absorbing debt (write-down or convertible) on the firm’s capital structure strategy. These features at least partly explain why the last loss-absorbing debt issues have mostly been of this variety rather than contingent convertibles. 4 In addition, WD investors should be reluctant to try manipulating the market because they might end up with severe losses if the write-down is triggered. Interestingly, this kind of debt precludes multiple equilibria.
Our main contribution is the thorough analysis of WD bonds. All bonds have (the same) finite maturity, the value of the firm’s assets obeys a diffusion process, a credit event may trigger the loss-absorbing mechanism, and default may occur before debt maturity subsequently to the credit event (a liquidity risk), or at debt maturity (a solvency risk), whether a credit event occurred or not. We develop a continuous time model in which the firm issues senior straight debt and junior WD debt.
While the literature analyzing contingent convertible debt is now vast, 3 to our knowledge Himmelberg and Tsyplakov (2012) is the only paper that considers the case of WD bonds. The purpose of this paper is to analyze the optimal capital and debt structure decisions when debt includes a write-down (hereafter WD) mechanism. Therefore, there is ample room for regulatory incentives, and in some cases obligations, imposed on banks and large firms to issue loss-absorbing, as opposed to straight, debts. (2015), this kind of government commitment is likely not to be credible to the financial market participants, given the contagious and possibly disastrous nature of financial crises. However, as recently argued by Gormley et al. It could be argued that a number of governments, such as the US with the Dodd-Frank 2010 legislation, subsequently promised not to grant further bailouts in order to abate “ too big to fail” perceptions among both investors and managers. The need for such debt designs has been emphasized during the 2008 financial crisis when regulators had to bail-out banks, and more generally large firms, with taxpayers’ money. Upon write-down or conversion, the firm’s leverage is lowered and losses can be absorbed. Both mechanisms are designed to help distressed firms overcome difficult times by reducing the amount of coupon payments. A contingent convertible debt is automatically converted into equity if the market value of the assets hits a predetermined level, and, otherwise, is redeemed at maturity to what extent is possible. 2 A write-down debt has its principal reduced if a given threshold for the asset value is hit.
Recently, two interesting new classes of debt with loss-absorbing features, write-down debt and contingent convertible debt, have been issued by various financial institutions (see Table 1). A financially distressed firm faces potential costly and time-consuming reorganizations, typically bankruptcy or debt restructuring, to alleviate the burden of debt.
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