Death Spiral Convertibles

Abstract

Death spiral convertibles are privately held convertible securities (preferred stock or debentures) with a conversion price that is set at a discount from the average (or sometimes the minimum) of past stock prices in a look-back period. Although, in theory, these securities have the potential to reduce agency costs of debt and problems related to adverse selection, they have been called death spirals because of their potential to create dilution and stock price declines. On the basis of all 487 issues announced before August 1998, we find that this bad reputation is indeed justified: an investor who buys the common stock of the issuer loses, on average, 34% of his wealth one year after the issue date. Although our sample period coincides with one of the strongest bull markets in U.S. history, in 85% of the cases one-year post-announcement returns are negative. However, we also find that issuers also experience a significant decline in operating profitability relative to benchmark firms.