Callable Bonds: A Risk‐Reducing Signalling Mechanism—A Reply

Abstract

ROBBINS AND SCHATZBERG [3] (HEREAFTER, RS) argued that callable bonds constitute a signalling Wall [6] (hereafter, Wall) responds that there exist examples, quite similar to the one presented in RS, for which short-term debt proves to be a superior instrument. In Wall's first example, short-term debt can signal good prospects although callable bonds cannot. A second example purports to show strictly superior risk-reduction capabilities when either short-term debt or callable bonds can signal. Wall contends, therefore, that the class of problems for which callable bonds serve as a signalling mechanism lacks generality. In this reply, we restrict our notion of what it means for securities offering to be risk-reducing at the same time that it signals. In doing so, we find that Wall's first example is one from a broad class of problems for which it is impossible both to reduce risk and to signal. The fact that callable bonds are not optimal for this problem is thus quite consistent with the idea that callable bonds constitute a signalling mechanism. Furthermore, we demonstrate that no power should be ascribed to Wall's second example, for it rests upon failure to note a subtle point in RS. Short-term debt is strictly superior in the second example only if we do not allow the firm to overcapitalize its investment project. If (as in RS) we do allow securities offerings that raise excess capital (the excess to be placed in a riskless investment opportunity), we can obtain a callable-bonds contract that equals the performance of short-term debt. If we introduce new corporate strategic behavior that seeks additional enhancement of the corporate manager's decision making (namely, selling off risky projects once information about prospects becomes symmetric), callable bonds prove strictly superior. Before providing these results, we begin by demonstrating that Wall's assertions are automatically questionable because short-term debt is equivalent to a degenerate subclass of callable bonds.