The long-run performance of firms that issue convertible debt: an empirical analysis of operating characteristics and analyst forecasts

Many firms issue hybrid securities, such as convertible debt, instead of standard securities like straight debt or common equity. Theoretical arguments suggest that convertible debt minimizes costs for firms facing high debt- and equity-related external financing costs. Theory also suggests that an appropriately designed convertible security provides efficient investment incentives. We show, however, that firms on average perform poorly following the issuance of convertible debt. The empirical evidence suggests that the efficient investment decisions predicted by theory are not in fact achieved by the actual design and issuance of convertible debt securities. An alternative interpretation of convertible debt offers is that investors ration the participation of some issuers in the seasoned equity market.     

Why Do Western European Firms Issue Convertibles Instead of Straight Debt or Equity?

Unlike their US counterparts, European convertible debt issuers tend to be large companies with small debt‐ and equity‐related financing costs. Therefore, it is puzzling why these firms issue convertibles instead of standard financing instruments. This paper examines European convertible debt issuer motivations by estimating a security choice model that incorporates convertibles, straight debt, and equity. We find that European convertibles are used as sweetened debt, not as delayed equity. This motivation is reflected in the debt‐like design of most European convertible issues.     

Convertible security design and contract innovation

This paper studies convertible security design for a sample of 814 issuers over the years 2000 through 2007. Using a nested logit model, we examine how firms choose fixed income claims and the method of payment. We find that fixed income claims are chosen to reduce corporate income taxes, minimize refinancing costs, and help mitigate managerial discretion costs. The method of payment choice frequently includes cash settlement features because they increase reported diluted earnings per share. Some of the cash settlement issuers also adopt other innovative financial strategies (share repurchase programs and call spread overlays) that inflate reported earnings per share. We find that firms needing debt capacity include mandatory conversion features.     

Stock Returns and Operating Performance of Securities Issuers

We examine long‐run stock returns and operating performance around firms’ offerings of common stock, convertible debt, and straight debt from 1985 to 1990. We find that pre‐issue abnormal returns are positive and significant for stock issuers, but not for convertible and straight debt issuers. The post‐issue mean returns show that common stock and convertible debt issuers experience underperformance during the post‐issue periods, but straight debt issuers do not. Consistent with these results, common stock issuers experience the best pre‐issue operating performance among all three types of issuers, and operating performance declines during the post‐issue periods for common stock and convertible debt issuers. Using a new approach in linear model estimations to correct heteroskedasticity and to adjust for finite sample, we find a positive relation between post‐issue operating performance and issue‐period stock price reactions. The results suggest that future operating performance is anticipated at the issue and that securities issues provide information on issuers’ future performance.     

Wealth effects of convertible bond and convertible preference share issues: An empirical analysis of the UK market

We examine the wealth effects of the announcement of issues of different types of convertible securities by UK firms and find significant negative effects on shareholder wealth. We however, also find that when the sample is partitioned by method of issue, privately placed convertible bonds, in contrast to previous research, exhibit a negative impact on firm wealth. Further, we also find negative wealth effects for firms that issue convertible securities to refinance previous debt or finance specific acquisitions. However announcements of convertible bond issues, for the purpose of financing capital expenditure schemes, show significant positive wealth effects. Finally, we find mixed support for testable predictions of the main theoretical models relating cross-sectional firm characteristics of convertible bond issuers to abnormal returns.     

UNDERSTANDING THE DESIGN OF CONVERTIBLE DEBT

There are now two dominant theories of convertible debt held by academic economists. One theory which has been called the "risk-shifting" hypothesis–effectively views convertibles as an alternative to straight debt. The second–known as the "sig-nalling" (or "backdoor-equity") theory-treats convertibles as an alternative to ordinary equity. This article attempts to unify (or at least to illustrate the relationship between) these two theories by focusing on the design of the securities.
In structuring a convertible, managers and their investment bankers must make a variety of decisions. Besides the coupon rate, face value, issue size, and maturity, managers must also decide the conversion ratio (the number of shares promised per bond) and the amount of call protection afforded investors. Several of these design features have the effect of making a convertible more like a straight debt or a straight equity issue. The hypothesis underlying the authors' recent research is that the issuers of debt-like convertibles are attempting to address a somewhat different financing challenge than the issuers of convertibles that behave more like equity. Their findings suggest that the primary aim of "debt-like" convertible issues is to address investors' uncertainty and concerns about risk, whereas the main goal of "equity-like" convertibles is to minimize the "information costs" associated with raising new equity.     

What we do and do not know about convertible bond financing

We review the literature on the issuance motives, shareholder wealth effects, and design of convertible bonds. Empirical studies on convertible debt issuance mainly focus on testing the predictions of four traditional theoretical models based on convertibles' potential to mitigate agency or adverse selection costs, and obtain mixed evidence. Recent studies on shareholder wealth effects of convertible bond issues highlight the need to control for arbitrage-related short selling and post-issuance risk changes. Studies on the determinants of convertible bond design uncover earnings management, as well as catering incentives to convertible arbitrage funds, as important determinants of innovations in convertible bond characteristics. Overall, our review indicates that recent empirical research on convertible debt provides valuable insights into issue motives and determinants of financial innovations, but also considers the broader question of how investor demand characteristics impact corporate finance decisions. We conclude with an overview of potential research questions to be addressed by future research on hybrid securities.     

THE CHOICE AMONG DEBT,EQUITY, AND CONVERTIBLE BONDS

The hybrid nature of convertible bonds continues to interest corporate financial managers, investors, and economists. While much theoretical and empirical research examines an issuer's choice between using straight debt and equity, little research evaluates how an issuer chooses among debt, equity, and convertible bonds. This study extends Marsh's [ 13 ] research on the differences between debt and equity issuers in the United Kingdom by examining U.S. industrial firms that issue debt, equity, or convertible bonds. It also illustrates how various distinguishing features influence the probability that each security will be issued.     

THE LONG-RUN PERFORMANCE OF CONVERTIBLE DEBT ISSUERS

We examine the long-run operating and stock price performance of 828 convertible debt issuers. Relative to matched, nonissuing firms, convertible debt issuers have small improvements in operating performance before the offer and significant declines in operating performance from pre- to post-issue. We examine the relation between several factors and operating performance. We find that for some pre- to post-issue periods, operating performance changes are positively related to firm leverage and the callability of the bond, and negatively related to performance run-up before the offer and investment in new assets. We also find some evidence that firms that issued equity in the three years before their convertible debt issue have larger declines in performance after the offer. Relative to matched, nonissuing firms, convertible debt issuers have superior stock price performance before the offer and significantly poor performance after the issue.     

The determinants of the hybrid security issuance decision for Australian firms

The Australian capital market has number of distinct characteristics that distinguish it from typical U.S. and European markets. There is a limited listed debt market where most firms use bank debt, convertible debt is not callable and stand alone warrants are used to raise capital. This paper examines the determinants of security choice for hybrid issuers in the Australian market. The results support the pecking order model and the impact of financial distress costs and taxation. Alternatively, the results provide support for the sequential financing model where firms with high profitability use convertible debt and firms with low profitability use warrants, to solve the sequential financing problem.     

VALUATION OF PRIMARY ISSUE CONVERTIBLE BONDS

Little empirical evidence is available on the nature of the trade-offs between the debt- and equity-like components of convertible bonds. Such information would be useful to firms considering the issuance of convertible bonds. Furthermore, complete understanding of the leverage implications of convertible bond issuance depends on the market's view of the proportions of the implicit debt/equity mix. The current study develops a two-equation model that estimates the relative contributions made to the value of primary issue convertible bonds by the debt and implicit warrant components. The model's distinct approach affords an opportunity to evaluate the empirical relationship between the value of the implicit warrant and the theoretical determinants of that value by isolating the individual components of the convertible bond's value.     

CONVERTIBLE SECURITIES: A TOLLBOX OF FLEXIBLE FINANCIAL INSTRUMENTS FOR CORPORATE ISSUERS

During the 1990s, convertible and equity-linked securities emerged as a major source of financing for U.S. corporate issuers. Issuance volume grew steadily throughout the decade and the secondary market value of U.S. convertible securities now exceeds $200 billion. In this overview of the market, the authors discuss the following: (1) the growth of issuance volume in the U.S. equity-linked market; (2) the basic characteristics of convertible securities; (3) convertible debt alternatives; and (4) convertible preferred alternatives.
As a result of the proliferation of new convertible structures, corporate issuers are now able to adjust coupon/dividend, conversion premium, and call protection in order to meet their tax, accounting, rating agency, and cost-of-capital objectives. Historically, the convertible new issue market has had a broad variety of issuers, spanning all industry sectors as well as both investment grade and high yield credits. But in the last two years, the most aggressive issuers have been technology-oriented companies, including telecommunications, Internet, hardware, software, and biotechnology concerns. Such technology-related issuers, which are often rated below investment grade and unable to secure straight debt capital, are generally in heavy-spending phases and view convertible bonds as a source of inexpensive financing. At the same time, investment-grade, "old-economy" issuers have continued to use convertible securities selectively, in most cases as cheap "quasi-equity" in the context of mergers and acquisitions, or as a tax-deferred strategy for selling cross-holdings of stock.     

FIRM PERFORMANCE AND SECURITY TYPE IN SEASONED OFFERINGS: AN EMPIRICAL EXAMINATION OF ALTERNATIVE SIGNALING MODELS

In this paper we examine the long-term performance of publicly traded firms that issue straight debt, convertible debt, or common stock. Declines in firm performance following issuance are consistent with declines in firm value at announcement and issuance, and suggest that convertible debt and common stock are substantially equivalent. This study is consistent with the pecking-order and Miller-Rock models, but inconsistent with the leverage-signaling model. Despite a significant decline following issuance, firms issuing common stock or convertible debt perform better, on average, than the industry before, at, and after issuance. This is consistent with younger, riskier, higher-growth firms being the predominant issuers of common stock and convertible debt.     

Hedge Fund Involvement in Convertible Securities

Convertible arbitrage hedge funds combine long positions in convertible securities with short positions in the underlying stock. In effect, hedge funds use their knowledge of the borrowing and short‐sale market to hedge themselves while distributing equity exposure to a large number of well‐diversified investors through their short positions. The authors argue that many “would‐be” equity issuers that would otherwise pay high costs in a secondary equity issue choose instead to issue convertible debt to hedge funds that in turn distribute equity exposure to institutional investors. This allows companies to receive “equity‐like” financing today at lower cost than a secondary equity offering. The authors' findings also suggest that more convertibles will be privately placed with hedge funds when issuer and market conditions suggest that shorting costs will be lower.     

Convertible debt and shareholder incentives

Given equity's convex payoff function, shareholders can transfer wealth from bondholders by increasing firm risk. We test the existing hypothesis that convertible debt reduces this classical agency problem of risk-shifting. First, we derive a measure of shareholders' risk incentives induced by convertible debt using a contingent claims framework. We then document that when risk-shifting incentives are high, the propensity to issue convertible (rather than straight) debt increases and the negative stock market reaction following convertible debt issue announcements is amplified. We further highlight that convertible debt is the only type of security that affects business risk durably downwards. Our conclusions support the agency theoretic rationale for convertible debt financing especially for financially distressed firms.     

Do Convertible Bond Issuers Cater to Investor Demand?

We examine the impact of fluctuations in investor demand for convertible securities on convertible bond issue volumes, pricing, and design. We find evidence of a positive impact of investor demand proxies on convertible bond issue volumes. We also document significantly lower convertible bond underpricing in periods with higher investor demand. The results hold in a variety of specifications, and are robust to controlling for firm‐specific and macroeconomic financing cost proxies. However, we obtain only limited evidence that issuers adjust the design of their convertible bond offerings in response to investor demand.     

Convertible debt and investment timing

In this paper we provide an investment-based explanation for the popularity of convertible debt. Specifically, we demonstrate the ability of convertible debt to alleviate and potentially totally eliminate the underinvestment problem of Myers (1977). A conversion feature induces shareholders to accelerate investment. This effect arises from the incentive of equity holders to accelerate the issuance of new equity, used to finance investment, since by investing early shareholders dilute the value of convertible debt holders by reducing their proportional claims to the firm's cash flows. Since the underinvestment effect and the accelerated investment effect work in opposite directions, convertible debt allows to mitigate or completely eliminate the debt overhang problem. In addition, we show that by choosing the right combination of straight debt and convertible debt, shareholders can, for a wide range of overall debt levels, commit to the investment strategy of an all-equity firm.     

Investor protection and convertible debt design

An important issue that firms consider when designing convertible debt is to specify security features such as conversion ratio, maturity date and call period. Following Lewis et al. [Lewis, M., Rogalski, R., Seward, J., 2003. Industry conditions, growth opportunities and market reactions to convertible debt financing decisions. Journal of Banking and Finance 27, 153–181], we employ a single measure that simultaneously considers all of these features: the expected probability (measured at issue date) that the convertible will be converted to equity at maturity. We find that firms in countries with stronger shareholder rights issue convertible debt with a higher expected probability of converting to equity. The positive association between the expected probability of conversion and shareholder rights is less pronounced in firms for which ownership structures create potentially high managerial agency costs. Specifically, in countries with stronger shareholder rights, firms with higher separation of control rights and cash flow rights tend to issue convertibles with lower probability of conversion. Furthermore, we find that large non-management block ownership strengthens the likelihood of issuing convertible debt with higher probability of conversion in countries with stronger shareholder rights. In contrast, firms in countries with stronger creditor rights issue convertibles with lower probability of conversion. We also document that the negative association between creditor rights and probability of conversion is more pronounced in firms with higher separation of control rights and cash flow rights.     

THE COSTS OF RAISING CAPITAL

We report the average costs of raising external debt and equity capital for U.S. corporations from 1990 to 1994. For initial public offerings (IPOs) of equity, the direct costs average 11.0 percent of the proceeds. For seasoned equity offerings (SEOs), the direct costs average 7.1 percent. For convertible bonds, the direct costs average 3.8 percent. For straight debt issues, the direct costs average 2.2 percent, although they are strongly related to the credit rating of the issue. All classes of securities exhibit economies of scale, although they are less pronounced for straight debt issues. IPOs also incur a substantial indirect cost due to short-run underpricing. Most large equity offers include an international tranche, although debt issues do not.     

What motivates exchangeable debt offerings?

Debt that is convertible into shares of a company other than the issuer is called exchangeable debt. Most firms that issue exchangeable debt hold large blocks of shares in several companies, and in this paper we study factors that influence the selection of a particular block to serve as the underlying asset for an exchangeable debt issue. Comparisons between issuers' holdings in different firms shed light on issuers' performance as monitors as well as their ability to engage in market timing. Holdings attached to these issues display superior past operating performance, but after the offer, both operating performance and stock returns decline. In contrast, we do not find similar systematic performance patters for the “other holdings” of exchangeable debt issuers.