Write-down bonds, credit risk and imperfect information

Highlights

• We develop a structural model of write-down bonds under imperfect information.

• The issuance of WD bonds could significantly improve firm value.

• The WD bonds increases corporate risk tolerance and reduces the risk of bankruptcy.

Abstract

A structural model of pricing Write-Down (hereafter WD) bonds under imperfect information has been developed to investigate the effect of WD bonds issuance on credit risk. Information is not only delayed but also asymmetrically distributed between managers and outside investors. We derive analytical solutions for corporate securities prices and find the issuance of WD bonds could significantly improve firm value via reducing bankruptcy cost. Our numerical results further demonstrate that the WD bonds issuance increases corporate risk tolerance and reduces the risk of bankruptcy and credit spreads under imperfect information.

Introduction

The recent global financial crisis has induced severe financial distress for even seemingly stable sectors such as “too big to fail” banks. To prevent the consequences of banking system collapsed that might lead severe adverse impact on the economy as a whole, governments across the world directly bail out these banks with the money of taxpayers, which inevitably leads to serious moral hazard problems.¹ Since the global financial crisis, regulators and researchers had gradually reached the consensus that it is necessary for banks to issue loss-absorbing contingent capital to reduce banks insolvency risk.

Write-down (WD, henceforth) bonds, a typical type of contingent capital with loss-absorbing features, has been designed to relief banks’ financial burden in distress by writing down or off the bank debt. Normally, the WD bonds has its principal reduced when the value of bank asset hits a predetermined level. Since the first issuance of WD bonds with 7 billion pounds face value by Lloyd Bank in November 2009, WD bonds has been increasingly welcomed and issued by various banks across the world. By the end of June 2020, China’s commercial Banks alone had issued a total of 2.3 trillion yuan in WD bonds.

While most of existing research on WD bonds, see Attaoui and Poncet, 2015, Li et al., 2018, among others, have been based on the assumption of perfect information, limited attempts have been made under imperfect information. In fact, in most modern corporations, equity-holders always delegate the exercise decision to managers who own special skills and expertise. In this situation, imperfect information arises because managers are closer to the day-to-day operations of the company than both shareholders and creditors.² In this paper, we consider shareholders and creditors as outside investors, while managers as “the insiders”. The bank insiders enjoy enormous discretion to act in their own private interests rather than in the interests of debt holders and shareholders. It naturally sets up barriers for outside investors to monitor by other means. Thus, outside investors receive delayed, or partial information.

In the standard incomplete information models, Ali, Li, and Zhang (2019) investigate managers’ control over the timing of information disclosure. For the benefit of private individuals, managers have an incentive to disclose good news about the health of firms in a timely manner and delay bad news. Indeed Armantier et al., 2015, Zia et al., 2018 find empirical evidence of delayed bank borrowing from the Federal Reserve’s Discount Window during the global financial crisis, which indicates banks are reluctant to rely on discount window credit for fund needs as this information disclosure might lead a bank default. Duffie and Lando (2001) suppose that investors cannot observe the issuer’s assets directly and receive instead only periodic and imperfect accounting reports, and analyse the implication of asymmetric information for term structures of credit risk and yield spreads on corporate bonds. Lindset, Lund, and Persson (2014) consider that information is incomplete because it is delayed for all agents and asymmetrically distributed between debtholders and shareholders. However, none of these studies investigate the impact of imperfect information on credit spreads of WD bonds and bank bankruptcy risk, which is the focus of this paper.

Our paper is most closely related to Attaoui and Poncet, 2015, Himmelberg and Tsyplakov, 2020, which propose a dynamic capital structure model to examine the optimal contract terms and incentive effects of Write-Down bonds under complete information. Nevertheless, those two papers on WD bonds do not take incomplete information into account. Along this research line, we develop a dynamic structure model which investigates WD bonds pricing and its effects on credit risk under incomplete information.³ The dynamics of the model are mainly reflected in that the firm’s cash flow fundamental is time-varying and, the dynamic capital strategy of a firm is due to write-down. Indeed the issuance of WD bonds provides a buffer for banks in distress by reducing coupon payment via write down. We find debt holders request higher credit spreads particular for risky WD bonds under imperfect information. Delayed information has limited impact on credit spreads for short-term bonds, however, it indeed makes long-term bonds more risky. Similar to Lindset et al. (2014), asymmetric information has a major impact on credit spreads, particular for WD bonds. Indeed, it is the asymmetric information that leads to high credit spreads for short-term bonds, as predicted in our model.

The rest of paper is organised as follows. Section 2 sets up the model of WD bonds under imperfect information. Section 3 provides securities pricing and the optimal default policy. Numerical results and economic analyses are presented in Section 4. Section 5 concludes.