Callable or Convertible Debt? The Role of Debt Overhang and Covenants

Abstract

Many U.S. corporate bonds are either callable or convertible. While callable bonds provide a higher coupon to bondholders in exchange for a firm's repurchase option of its claim, convertible bonds offer investors the option to exchange a firm's debt to equity. This paper analyzes the choice between these two debt contracts. Using a dynamic capital structure theory model that includes an investment choice, we show that firms which are more exposed to debt overhang issue callable rather than convertible bonds. Convertible bonds are preferred if the firm has a higher initial level of debt. However, if bonds have covenants attached, the firm is more likely to issue callable bonds. Our empirical findings support the theory.