Financial Distress Costs and Delayed Calls of Convertible Bonds: An Empirical Analysis

Theoretical analysis implies that optimal call policy would be to call the bonds as soon as the conversion value equals the call price. Empirical studies, however, report that firms appear to systematically delay the call and the difference between the conversion value and the call price is large at the time of the call. This study examines convertible bond calls between 1977 and 1993, with a view to explain the large difference between the conversion value and the call-price at the time of the call. A large majority of the firms calling the bonds have cash-flow incentive to call the bonds in that the after-tax interest payments are higher than the dividends on the converted shares. The large difference between the conversion value and the call price is positively related to the risk characteristics of the firm. Evidence seems to support the view that risk aversion and fear of potential financial distress may explain the large difference at the time of call between the conversion value and the call price.