The impact of rights issues of convertible debt in Australian markets

Australian convertible debt issues are rights issues of non-callable securities and are issued in a market characterised by thin trading, significant institutional investor participation rates and a high number of resource firms. However, this study documents a significant negative announcement effect for rights issues of convertible debt, similar to international evidence. An analysis of the determinants of the announcement effect supports variants of the information asymmetry and agency cost hypotheses. The results do not support the convertible debt models of Kim [Kim, Y., 1990. Informative conversion ratios, a signalling approach. Journal of Financial and Quantitative Analysis 25, 229–243], Brennan and Kraus [Brennan, M., Kraus, A., 1987. Efficient financing under asymmetric information. Journal of Finance 42, 1225–1243], Green [Green, R.C., 1984. Investment incentives, debt and warrants. Journal of Financial Economics 13, 115–136] but some support is found for Stein's [Stein, J., 1992. Convertible bonds as backdoor equity financing. Journal of Financial Economics 32, 3–22], convertible debt model and Mayers [Mayers, D., 1998. Why firms issue convertible bonds: the matching of financial and real investment options. Journal of Financial Economics 47, 83–102], sequential financing model. However, support is found for Brous and Kini [Brous, P.A., Kini, O., 1994. The valuation effects of equity issues and the level of institutional ownership: evidence from analysts’ earnings forecasts. Financial Management 23, 33–46], equity issue based external monitoring model and Eckbo and Masulis [Eckbo, B., Masulis, R., 1992. Adverse selection and the rights offer paradox. Journal of Financial Economics 32, 292–332], rights issue adverse selection model.     

Operating Performance and Stock Returns of Firms Calling Convertible Preferred Stocks

Abstract:   Using methodologies developed by Barber and Lyon (1996 and 1997 ), we examine the long‐run operating performance and stock returns of firms around in‐the‐money calls of convertible preferred stock. Our study intends to be a direct test of the hypothesis that managers call in‐the‐money convertibles when they view a decline in the firms' performance. We find no evidence that calling firms underperform non‐calling benchmark firms. On the contrary, we find mild evidence that the post‐call operating performance of calling firms is better than a carefully selected group of benchmark firms and call firms' post‐call stock returns are no worse than benchmark firms.     

Risk Changes around Calls of Convertible Bonds

We examine changes in equity and asset betas around convertible bond calls and report two major findings. First, calling firms exhibit an increase in asset betas following the call. We argue that the finding is consistent with the implications of the sequential financing theory but not of the backdoor equity financing theory. Second, abnormal returns at call announcements are negative only for the subsample of firms that also exhibit an increase in equity beta. We conclude that risk changes help explain the market reaction to convertible bond calls.     

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.     

A SEQUENTIAL SIGNALING MODEL OF CONVERTIBLE DEBT ISSUE AND CALL POLICIES

This paper offers a new explanation for why some risk‐averse firms may prefer to issue callable convertible debt. Here, the convertible debt issue and call policies are integrated into a unified financing policy. It is then shown that for firms with relatively low unsystematic risk, convertible debt issuance followed by an appropriate in‐the‐money signaling call policy reduces more unsystematic equity risk than equity, callable straight debt, or their combination. The model is modified to incorporate asymmetric information at the issue stage to explain the stock price behavior at announcements of convertible debt sales.     

可转换债券在公司连续融资中作用机理的研究——以万科股份有限公司为例

本文通过模型分析了可转换债券在公司连续融资中的作用机理;并结合万科公司利用可转换债券融资的案例,分析了万科转债在万科公司连续融资中发挥的作用。在万科公司以未来投资期权价值不确定为基础的连续融资过程中,当投资期权项目被证实有价值时,通过可转换债券的赎回(强制转换)把初始项目积累的资金转向有价值的投资期权项目,有利于万科公司有价值投资期权项目的后续融资,验证了Mayers(1998)的连续融资假说。     

Fully revealing equilibria with suboptimal investment

Myers and Majluf [Myers, S.C., Majluf, N.S., 1984. Corporate financing and investment decisions when firms have information that investors do not have. Journal of Financial Economics 13, 187–221.] showed that mispriced securities can lead managers with private information to invest inefficiently. It seems plausible that this problem would disappear in a fully revealing equilibrium, since information asymmetries are resolved and securities are priced correctly. In fact, Constantinides and Grundy [Constantinides, G.M., Grundy, B.D., 1989. Optimal investment with stock repurchase and financing as signals. Review of Financial Studies 2, 445–465.] claim that, in their model, any fully revealing equilibrium has efficient investment. This claim is incorrect, as infinitely many inefficient equilibria exist for the very example they work out. The inefficient outcomes survive the standard signaling-game equilibrium refinements. There are also examples that have fully revealing equilibria with inefficient investment but none with efficient investment.     

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.     

CAPITAL STRUCTURE MANAGEMENT AS A MOTIVATION FOR CALLING CONVERTIBLE DEBT

Using a matched-pairs methodology, we present empirical evidence of systematic changes within a corporation that are associated with calls of convertible debt. We find that calling firms experience significantly greater growth than noncalling firms in the same industry, as measured by retained earnings and long-term debt. Also, the converted debt provides a significant source of new book equity, and calling firms issue significantly less other new equity. The pattern of growth in balance sheet accounts is consistent with the pecking order hypothesis and supports the notion that some firms call convertible debt to reduce their total cost of obtaining additional external financing. The evidence also shows that, on average, calling firms experience a significant decline in their leverage ratio based on book value but no significant change in their leverage ratio based on market value of equity. This is consistent with the call's being used as part of the firm's management of its capital structure.     

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.     

CONVERTIBLE BONDS: MATCHING FINANCIAL AND REAL OPTIONS

For companies whose value consists in large part of “real options”‐ growth opportunities that may (or may not) materialize‐convertible bonds may offer the ideal financing vehicle because of the matching financial options built into the securities. This paper proposes that convertible debt can be a key element in a financing strategy that aims not only to fund current activities, but to give companies access to low‐cost capital if and when their real investment options turn out to be valuable. In this sense, convertibles can be seen as the most cost‐effective solution to a sequential financing problem‐how to fund not only today's activities, but also tomorrow's growth opportunities (some of them not yet even foreseeable). For companies with real options, the ability of convertibles to match capital inflows with corporate outlays adds value by minimizing two sets of costs: those associated with having too much (particularly equity) capital (known as “agency costs of free cash flow”) and those associated with having too little (“new issue” costs). The key to the cost‐effectiveness of convertibles in funding real options is the call provision. Provided the stock price is “in the money” (and the call protection period is over), the call gives managers the option to force conversion of the bonds into equity. If and when the company's investment opportunity materializes, exercise of the call feature gives the firm an infusion of new equity (while eliminating the debt service burden associated with the convertible) that enables it to carry out its new investment plan. Consistent with this argument, the author's recent study of the investment and financing activities of 289 companies around the time of convertible calls reports significant increases in capital expenditures starting in the year of the call and extending three years after. The companies also showed increased financing activity following the call, mainly new long‐term debt issues (many of them also convertibles) in the year of the call.     

The Information Content Of Calls Of Debt: Evidence From Long-Run Stock Returns

We examine the long‐run performance of the common stock of firms following calls of both straight and convertible debt from 1945 to 1995. Using a sample of 718 calls of straight debt, we find an average abnormal return in the five years following the call of between 0.16% and 0.34% per month, which compounds to an economically and statistically significant 11% to 22% over the five‐year period. This evidence of overperformance following calls shows a distinct symmetry between the straight debt and equity markets. Issues of debt and equity are both followed by long‐term underperformance, whereas stock repurchases and debt calls are both followed by long‐run overperformance. For our sample of 713 calls of convertible debt, we find little systematic evidence of abnormal performance following the call. Some researchers suggest that calls of convertible debt provide negative signals to the market. Our results provide no support for this claim. In contrast, our evidence of marginal positive long‐run returns provides weak support for the model that calls of convertible debt signal the realization of profitable investment options, and for the price pressure hypothesis.     

Corporate financial and investment policies when future financing is not frictionless

We study a model in which future financing constraints lead firms to have a preference for investments with shorter payback periods, investments with less risk, and investments that utilize more pledgeable assets. The model also shows how investment distortions towards more liquid, safer assets vary with the marginal cost of external financing and with firm internal cash flows. Our theory helps reconcile and interpret a number of patterns reported in the empirical literature, in areas such as risk-taking behavior, capital structure choices, hedging strategies, and cash management policies. For example, contrary to Jensen and Meckling [Jensen, M., Meckling, W., 1976. Theory of the Firm: managerial behavior, agency costs, and ownership structure. Journal of Financial Economics 305–360], we show that firms may reduce rather than increase risk when leverage increases exogenously. Furthermore, firms in economies with less developed financial markets will not only take different quantities of investment, but will also take different kinds of investment (safer, short-term projects that are potentially less profitable). We also point out to several predictions that have not been empirically examined. For example, our model predicts that investment safety and liquidity are complementary: constrained firms are specially likely to decrease the risk of their most liquid investments.     

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.     

The external financing of investment

This paper investigates the impact of investment characteristics on the financing choice. We investigate instances of seasoned equity, bank debt, straight non-bank debt, and convertible issues by U.S. firms where the stated use of proceeds is capital expenditure and where we are able to hand-collect and classify the characteristics of the investment. Controlling for a firm's existing assets, capital structure and valuation, we document a strong empirical link between an investment's characteristics and the choice between debt and equity financing. Factor analysis indicates that the principal determinant of the financing choice is whether an investment's payoffs can be described as a hit or miss.     

The profitability of asset sales as an explanation of asset divestitures

Using Korean fixed asset divestiture data, I extend the investigation of the financing hypothesis of divestitures proposed by Lang et al. (Lang, L., Poulsen, A., Stulz, R., 1995. Asset sales, firm performance, and the agency costs of managerial discretion, Journal of Financial Economics 37, 3.37). In particular, I take into account the profitability of announced asset divestitures and I employ a unique sample constructed to avoid effects that might confound the results. I also take into account the financial condition of the selling firms. The results are consistent with the financing hypothesis proposed by Lang et al. and show that the financing hypothesis of divestitures is robust to controls for the profitability of asset sales and the financial condition of selling firms.     

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.     

Announcement effects of convertible bond loans and warrant-bond loans: An empirical analysis for the Dutch market

This study investigates the announcement effects of offerings of convertible bond loans and warrant-bond loans using data for the Dutch market. The event study analysis shows that announcement effects of convertible bonds are associated with positive but insignificant abnormal returns and that announcements of warrant-bonds are associated with significant positive abnormal returns. These findings are similar to the results for Japanese hybrid debt, as reported by Kang et al. (1995) (Kang, J.K., Kim, Y.C., Park, K.J., Stulz, R.M., 1995. Journal of Financial and Quantitative Analysis, pp. 257–270) and Kang and Stulz (1996) (Kang, J.K., Stulz, R.M., 1996. Review of Financial Studies, pp. 109–139), but they contrast with studies for the United States that generally find significant negative abnormal returns for convertible bond loans and insignificant negative abnormal returns for warrant-bond loans. Our results cannot be attributed to differences in the corporate governance structures of the Netherlands and the United States. We find that the positive abnormal returns for the warrant-bond loans are caused by the packaging of the announcements with other (good) firm-specific news.     

Costly external financing, investment timing, and investment–cash flow sensitivity

This paper examines the effects of costly external financing on the optimal timing of a firm's investment. By altering the optimal investment timing, costly financing affects current investment and the sensitivity of investment to internal cash flow. Importantly, the relation between the cost of external funds and investment–cash flow sensitivity is non-monotonic. Investment–cash flow sensitivity is decreasing in the cost of external financing when it is relatively low and is increasing in the financing cost when it is high. Empirical tests examining investment–cash flow sensitivities within groups of firms classified by proxies for their costs of external funds provide evidence consistent with the model. The model and the empirical results complement recent studies by Cleary, Povel and Raith [Cleary, S., Povel, P. and Raith, M., 2007. The U-shaped investment curve: theory and evidence, Journal of Financial and Quantitative Analysis 42, 1–39.] and Almeida and Campello [Almeida, H. and Campello, M., in press, Financial constraints, asset tangibility and corporate investment, Review of Financial Studies.] that show a non-monotonic relation between firms' investment and the availability of internal funds.     

Why is Convertible Debt Subordinated? An Investment‐Based Agency Theory

This paper offers an agency‐based explanation for the junior priority status of convertible bonds. Using a simple economic model, I show that when convertible and straight debt have equal priority, shareholders can prefer value‐decreasing projects, which results in wealth transfers from bondholders to shareholders; and I prove that this problem is solved when convertible debt is subordinated. Empirical evidence supports the theory. I find that firms with greater potential for investment‐based agency conflicts are more likely to issue subordinated convertible debt, and firms with senior convertible debt are more likely to deviate from the optimal investment policy.