Capital Structure Pre-Balancing: Evidence from Convertible Bonds

Abstract

A large body of the corporate finance literature is devoted to capital structure. This literature examines whether firms have a target capital structure, and whether they actively rebalance their capital structure towards a target. Conversion of a convertible bond causes a drop in leverage, which target capital structure theory suggests should be rebalanced in the future. Consistently, I find that following a realized conversion, firms rebalance their positions in less than a year. When the stock price passes the conversion price threshold for a convertible bond, the firm expects this drop in leverage to occur in the near future. Using a regression discontinuity design around the conversion price threshold, for those conversions that are decided by investors, not by the firm my paper documents a 21% increase in leverage before an actual drop in leverage. That is to say, firms do not wait for the realization of leverage shocks, but rather respond to anticipated shocks. A quantile treatment effect analysis reveals the effect to be a hump-shaped function of leverage, with a peak for firms with a leverage ratio around the 70th percentile.