Abstract
We develop a model with asymmetric information and agency problems that is able to explain simultaneously three empirical regularities associated with the issuance and conversion of convertible bonds. First, the model predicts that the negative stock price reactions observed when convertible bonds are issued are related to agency conflicts between firm management and stockholders, and to the type of firm that is issuing convertible debt. Second, the negative returns observed when bonds are subsequently called are explained in an equilibrium in which only bad managers call their in-the-money convertibles in low value states of nature. Third, the model explains the less negative returns seen at the redemption announcement day (compared to those observed at the issuance announcement day). We also provide empirical evidence in support of the model propositions. In short, we find that firms with a higher probability of agency conflicts exhibit significantly more negative stock price reactions at the offering announcement day and are more likely to force conversion of their in-the-money convertible bonds. Finally, we also find that firms that call out-of-the-money convertibles do not experience negative returns at the redemption announcement day.
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