Contingent convertibles, Prof Theo Vermaelen, Potash, shareholders and bondholders..

Happened to read a news article from Prof. Theo Vermaelen, about Contingent Convertibles. Firstly he defines these class of bonds as ones that are offered in financial crisis times by Banks(example Lloyds TSB) which are triggered once the capitalisation falls below a specified ratio say 5 %.Investopedia defines it as " A security similar to a traditional convertible bond in that there is a strike price (the cost of the stock when the bond converts into stock). What differs is that there is another price, even higher than the strike price, which the company's stock price must reach before an investor has the right to make that conversion"These bonds are nicely suited for bond holders who can exit at the same price of their investment.
(A video of Prof. Theo is available at http://www.cnbc.com/id/15840232/?video=1540724090&play=1)Basically it is call option that converts bonds into stock(or fresh equity) after breaching a specific trigger. This is specially useful in case of risky assets such as Bank capital adequacy ratios.If the capital fall below 5 % then bonds can be converted into stock and the capital can reach to 7%(just an simple example). Of course there is an incentive for bondholders to convert into shares, they receive more shares than the corresponding buying power of the bonds as in the normal times(as against in times of distress)
In their new paper Vermaelan and others propose a new security, the Call Option Enhanced Reverse Convertible (COERC). The security is a form of contingent capital, i.e. a bond that converts into equity when the market value of equity relative to debt falls below a certain trigger. The conversion price is set significantly below the trigger price and, at the same time, equity holders have the option to buy back the shares from the bondholders at the conversion price. Compared to other forms of contingent capital proposed in the literature, the COERC is less risky in a world where bank assets can experience sudden jumps. Moreover, the structure eliminates concerns about putting the company in a "death spiral" as a result of manipulation or panic. A bank that issues COERCs also has a smaller incentive to choose investments that are subject to large losses.
All this points out to a tricky territory for the investors. Also the strategies proposed above seem to be significantly tilted towards reducing the "areas of conflict" between bondholders and shareholders" Worth mentioning here is the pecking order theory at the time of financial distress. Also COERC and other Contingency convertibles offer companies an option to save themselves from financial distress by recapitalising through swapping of equity among two(main) principals .i.e. shareholders and bondholders.
Potash is not going down under to BHP, as of yet. The offer price of 130 a share was deemed too low by the board and they expect at least 160 offer to emerge from BHP. Analyst expect BHP to come up with a revised offer. Looks to be a another big acquisition story which will keep finance watchers on the hooks....


Link to the COERC article is here:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1656994