Is Convertible Debt a Substitute for Straight Debt or
for Common Equity?
Craig M. Lewis
Owen Graduate School of Management
Nashville, TN 37203
Richard J. Rogalski
Amos Tuck School of Business
Hanover, NH 03755
James K. Seward
Graduate School of Business
University of Wisconsin-Madison
Madison, WI 53706
*The authors thank Kooyul Jung, Yong-Cheol Kim and Rene Stulz for providing their equity and debt security offer data set. They also thank seminar participants at Miami, Vanderbilt and Wisconsin, the 1999 American Finance Association Meeting, the 1999 European Finance Management Association meeting,; especially Espen Eckbo, Wayne Mikkelson, David Parsley and Hans Stoll for their helpful comments. Sarah Leonard provided expert data management assistance.
This paper examines the ability of the risk-shifting hypothesis and the backdoor equity hypothesis to explain firms’ decisions to issue convertible debt. Using a security choice model that incorporates pre-offer issue, issuer, and macroeconomic information, we document significant variation in the market reaction to new convertible debt issues depending on whether investors expect the motivation for issuance to be asset substitution or asymmetric information. Our results suggest that both motives explain the use and design of convertible debt. Some firms issue convertible debt instead of straight debt to mitigate the costs of bondholder/stockholder agency conflicts. Other issuers use convertible debt instead of common equity to reduce the costs of adverse selection. Thus, in contrast to standard securities like straight debt or common equity, which solve some financing problems but exacerbate others, hybrid securities such as convertible debt are seen as providing a more flexible funding choice that can solve conflicting financing problems.
Financial economists study the security issue decision to understand more fully why firms choose to issue a particular security and how investors in financial markets react to that choice. The research documents several results about investor reaction to the announcement of convertible debt security offers. First, price reactions to convertible debt security offer announcements are negative and statistically significant. Second, the average price reaction to convertible debt security offer announcements lies between the average price reactions to common equity and straight debt security offer announcements. Since existing research has been unsuccessful in identifying factors that explain these announcement period results, there is little definitive empirical evidence that explains either the convertible debt issuance decision or investor reactions to the issuance decision.
The purpose of this paper is twofold. The first is an examination of the decision to raise capital using a hybrid security like convertible debt rather than a standard security like straight debt or common equity. Existing research suggests that the choice between straight debt and common equity is partially predictable. We extend this literature by proposing and implementing a security choice model that includes non-standard security choices like convertible debt. Our results indicate that pre-offer issue, issuer, and macroeconomic information can reliably explain issue choices.
Our second objective is to re-examine the information content of convertible debt security offer announcements. This is important because, even though existing studies have demonstrated a significantly negative stock price reaction to convertible debt offerings (Dann and Mikkelson, (1984) and Eckbo, (1986)), they fail to document a significant cross-sectional relation between excess returns and firm specific explanatory variables. Recent research suggests that investor reaction to straight debt announcements can be explained by the partial anticipation of the offer (see, e.g., Chaplinsky and Hansen,...
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