Convertible debt issuance,capital structure change and financing-related information: Some new evidence

This paper provides evidence on the valuation effects of convertible debt issuance. Common stockholders earn significant negative abnormal returns at the initial announcement of a convertible debt offering, and also at the issuance date. In contrast, the average valuation effect on common stock at the announcement of non-convertible debt offerings is only marginally negative, and is zero at issuance. The significant negative average effect on common stock value appears not to be systematically related to either the degree of leverage change induced by the convertible debt issuance or the extent to which the proceeds from issuance are used for new investment or to refinance existing debt. If, as appears likely, the issuance of convertible debt on average increases financial leverage, these results are inconsistent with evidence from other recent studies documenting common stock price effects of the same sign as the change in leverage. The evidence suggests that convertible debt offerings convey unfavorable information about the issuing firms, but the specific nature of such information remains unidentified.     

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.     

Convertible calls and corporate taxes under asymmetric information

This paper develops a signalling model of call of convertible securities (bonds or preferred stock) in the presence of corporate taxes and asymmetric information about future earnings. In equilibrium, managers with relatively unfavorable information call to force convertible holders to convert to common stock (in spite of the loss of corporate tax benefits if the convertibles are bonds), while those with relatively favorable information do not call. The model predicts that the announcement period common stock returns are more negative at the call of convertible bond than at the call of convertible preferred stock. Furthermore, we predict that when the importance of the tax deductibility of interest differs among firms, so does the stock price reaction to the announcement of convertible debt call. Specifically, the loss of equity value at the announcement decreases with the amount of non-debt tax shield that the calling firm owns, decreases with the book value of convertible debt called, and increases with corporate taxes.     

Convertible calls and security returns

The study examines the impact of convertible security calls on securityholder's wealth. On average common stock values fall by approximately two percent at the announcements of convertible debt calls, but common stockholder's wealth is unaffected by convertible preferred stock calls. These findings are consistent with a corporate tax effect. A small average decrease in firm value is also found at the announcements of convertible debt calls. The study raises, but leaves unanswered, the interesting question of what motivates managers to make capital structure decisions that reduce stockholder wealth and firm value.     

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.     

Changes in risk characteristics of firms issuing hybrid securities: case of convertible bonds

The present paper examines changes in risk characteristics of a firm when it issues convertible bonds by studying the change in beta before and after the issuance of convertible bonds. Using a sample of 149 firms, strong evidence was found of change in beta, along with significant heterogeneity across firms. On average, the beta of a firm issuing convertible bonds declines, although 40 per cent of firms showed an increase in beta. A cross‐sectional regression shows that after controlling for the reversion‐to‐mean phenomenon, the change in beta is significantly related to potential dilution of equity as well as to increase in debt, but is not significantly related to either the change in bond rating of a firm or to the stated use of funds from issuance.     

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.     

Foreign capital raising by Indian firms: An examination of domestic stock price response

We examine the domestic stock price response to foreign capital issuance by Indian firms. Firms have extensively used foreign equity and convertible foreign debt sources since 1994. The role of foreign investment bankers, size of the issue, firm's growth opportunities, and other factors are examined in the cross-sectional analysis of domestic stock price response. We find that firms experience positive stock price response to both equity and debt issues abroad, with greater response to issuance of American Depositary Receipts (ADRs), and financing high corporate growth.     

Investment and financing activity following calls of convertible bonds

The staged financing hypothesis of Mayers [Mayers, D., 1998. Why firms issue convertible bonds: The matching of financial and real investment options. Journal of Financial Economics 47, 83–102] predicts that investment and financing activity will increase following in the money convertible bond calls. The prediction for out of the money convertible calls is different: no increase is expected. We study the rate of both corporate investment and external financing around forced conversions using benchmarks that are analogous to those recommended by Barber and Lyon [Barber, B., Lyon, J., 1996. Detecting abnormal operating performance: The empirical power and specification of test statistics. Journal of Financial Economics 41, 359–400]. We also examine the cross-section of changes in investment and financing activity. Conversion-forcing firms exhibit an increase in both capital expenditures and debt financing around the year of the convertible bond call; however, the same result holds for the sample firms that conducted out-of-the-money convertible calls. Further, there is no relation between changes in investment activity and changes in debt issuance at the firm level. The evidence is inconsistent with the notion that forced conversions serve as a catalyst for staged financing and investment.     

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.     

EXCHANGEABLE DEBT CALLS AND SECURITY RETURNS

Exchangeable calls are not convertible into the calling firm's common stock but into the common stock of a target firm in which the calling firm has an ownership position. In addition to reducing leverage, exchangeables change the asset composition of the calling firm through the divestiture of the calling firm's ownership stake in the target firm. In contrast to the evidence on convertible calls, our findings indicate that announcements of exchangeable debt calls are not associated with an abnormal capital loss for the calling firm shareholders. For target firms, announcements of exchangeable calls reduce shareholder wealth. A lower probability of takeover resulting from diffusion of ownership concentration of the target firm's common stock may contribute to this result.     

Are there windows of opportunity for convertible debt issuance? Evidence for Western Europe

This paper hypothesizes that hot convertible debt windows represent periods with lower convertible debt-related financing costs. Supporting this premise, we find that the stock price impact of Western European convertible debt announcements is significantly less negative during hot convertible debt windows. Importantly, this result holds while controlling for equity and straight debt issuance volumes and for macroeconomic conditions. In addition, stockholders are less sensitive to issuer- and issue-specific financing costs during hot convertible debt markets. Overall, these findings indicate that hot convertible debt markets represent windows of opportunity for convertible debt issuance. Firms with high idiosyncratic financing costs act accordingly by timing their convertible debt offering during a hot market.     

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.     

Valuation Effects of New Securities Issuance by Bank Holding Companies: New Evidence

This study examines the announcement impact of bank holding company (BHC) security offerings on shareholder wealth. The results from this study regarding the effects of preferred stock, convertible debt, and straight debt issuances are largely consistent with previous studies. However, in contrast to previous studies pertaining to both BHCs and nonfinancial firms, this study does not find statistically significant negative announcement effects of common stock issues. This particular finding is consistent with the argument that an increase in the capital ratio may have a positive impact on common stock prices of BHCs under certain circumstances.     

Convertible Bonds and Stock Liquidity

This paper shows that the probability of exercise of convertible bonds issued against a firm’s stock directly affects the liquidity of the stock itself. Using the ratio of absolute stock return to its dollar volume as a proxy for stock liquidity I demonstrate that there is a direct and positive relationship between conversion probability and stock liquidity while controlling for firm size, book to market equity value and firm beta. I describe the effect of unlisted convertible debt on the liquidity of listed firms in the US, Korea and Singapore. The effects of conversion probability on stock liquidity are less pronounced for smaller firms, which helps explain time series variations in the liquidity premiums for smaller firms over time. The relationship between convertibles and stock liquidity is mainly attributed to the expected increase in the number of shares available for trade upon conversion and the expected change in the capital structure of the firm.     

Industry conditions,growth opportunities and market reactions to convertible debt financing decisions

Firms that issue convertible debt have high debt- and equity-related costs of external finance. Existing theories of convertible debt finance differ primarily in their identification of the specific causes of the debt- and equity-related costs of external finance. To assess the theoretical issuance motives separately, we propose a simple framework that characterizes how issuers should design convertible debt to efficiently mitigate specific debt- and equity-related costs of external finance. We provide evidence from 588 security offer announcements that supports the hypotheses that: (1) convertible debt can be designed to mitigate different combinations of debt- and equity-related costs of external finance and (2) share price reactions depend on the security design decisions. The results also illustrate that the relations between firm value, financial leverage, investment opportunities, and the rate of future growth are more complex among convertible debt issuers than situations where firms issue standard financial securities.     

Dynamic capital structure with heterogeneous beliefs and market timing

This paper builds a dynamic trade-off model of corporate financing with differences in belief between the insider manager and outside investors. The optimal leverage depends on differences of opinion and can differ significantly from that in standard trade-off models. The manager's market timing behavior leads to several stylized facts, such as the low average debt ratios of firms in the cross section, the substantial presence of zero-debt firms that pay larger dividends and keep higher cash balances than other firms, and negative long-run abnormal returns following stock issuance. Market timing behavior leads to substantial losses of firm value through excessive financing activities. Market timing and debt conservatism depend negatively on shareholder control of the firm.     

The underreaction hypothesis and the new issue puzzle: evidence from Japan

This article investigates the long-term equity performance ofJapanese firms issuing convertible debt and equity. We findthat issuing firms perform poorly (except for equity rightsissues) compared to nonissuing firms even though the stock-pricereaction to convertible debt and equity issues is not negativefor Japanese firms. This underperformance is strongest for firmsissuing public convertible debt. In contrast to the United States,poor performance is not concentrated in smaller firms and infirms with a high market-to-book ratio. Simple behavioral explanationsadvanced for the new issue puzzle in the United States do notseem consistent with the Japanese experience.     

UNITS OF DEBT WITH WARRANTS: EVIDENCE OF THE “PENALTY-FREE” ISSUANCE OF AN EQUITY-LIKE SECURITY

While units of debt with warrants are not structured as perfect substitutes for convertible bonds, there is reason to believe that firms view the two securities as viable alternative methods of raising funds. Analyses of the capital market effects of the announcement of the plan to issue and the issuance of units of debt with warrants provide unique evidence of the “penalty-free” issuance of an equity-like security. Evidence is found to support the conjecture that units are typically issued by smaller, riskier firms than are convertible bonds. However, there is no evidence that the use of this security is interpreted by the market as a sign of financial distress.