19. Convertible bonds

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Topics

• 19. Convertible bonds
• D. Mayers

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Convertible bonds Why?

• Reduce agency cost (conflict between bondholders
  and stockholders)
• 1. Underinvestment
• 2. Asset substitution
• 3. Claims dilution
• CB has less 2 and 3 because CB will share the
  benefit (bondholder part will lose but
  stockholder part will gain)
• CB has less 1 because interest rate is lower and
  default probability is lower

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Convertible bonds Why?

• Information asymmetry
• Firm will issue equity when it is overvalued
• Convertible has equity component
• Announcement effect
• Equity -3
• CB -2
• Debt 0
• It is a cost if the issuing firm is a good one
  but is mistaken to be a bad one.

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Convertible bonds Why?

• Reduce the impact of uncertainty about firm risk
• Higher risk will reduce the value of the bond
  component, but will increase the value of the
  stock component
• Evidence CB issuers are smaller, riskier

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Convertible bonds Why?

• Signal high valuation (Backdoor equity financing
  hypothesis)
• Growth firms are reluctant to issue bond
• agency cost
• Growth firms are reluctant to issue equity
• Equity are likely to be undervalued (diluted)
• Managers with great confidence may choose to
  build equity by issuing CB and planning to force
  conversion (call provision) when price rises

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Convertible bonds Why?

• Plan for a possible future investment opportunity
• Future is uncertain, it may have no good
  opportunity (there will be overinvestment if cash
  is available) or have good investment opportunity
  (there will be dilution cost if cash is not
  available)
• When there is no opportunity, stock price is low,
  CB is not converted, and the firm repay CB.
• When there is opportunity, stock price goes up,
  CB is converted, and the firm has money to
  invest. It also has more room to issue new debt
  to finance new investment.
• Widely used in start-up companies.

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Convertible bonds Evidence

• Most CB is converted
• CB issuers have higher growth opportunities (RD,
  M/B) D/E

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Convertible bonds Evidence

• Announcement effect
• It is less negative for companies with higher
  post-issue capital expenditure and high M/B
• Investment activity
• Higher in year 0 (year of call) and 1
• Financing activity
• Higher issue from year 0 (year of call),
  especially long-term debt