Do High-Yield Bonds Have an Equity Component?

Abstract

N controversy has arisen concerning the implicit component of high-yield bonds. On the one hand, Reilly (1994) reports that investment houses regard the securities as low-quality credits that have characteristics of common stocks. Shane (1994) writes, A low-grade bond can be viewed as a hybrid security consisting of a government bond and a claim on the issuing firm's Economist Lawrence Summers more colorfully characterizes certain types of high-yield issues as equity in drag. I In sharp contrast, Christensen and Faria (1994) deny that high-yield debt behaves like equity. They base their conclusion on the announcement effect of new issues of straight (nonconvertible) high-yield debt on the issuer's stock price. As Christensen and Faria note, previous empirical studies have demonstrated that when companies announce plans to sell new stock or convertible securities, their share prices react negatively. In contrast, announcements of planned debt issuance do not have a significant negative impact on stock prices. Christensen and Faria expand upon earlier research by testing the impact on stock prices of announcements of planned offerings of bonds rated double-B or lower by Standard & Poor's. Their sample consists of 155 convertible and 127 straight completed offerings, covering the period 1979-1985. They find that the convertible announcements elicited a negative stock market reaction but that the straight debt announcements did not. The findings are consistent with the conclusions of previous studies, which deal with investment-grade bonds. Christensen and Faria say that their results show no evidence that straight high-yield debt behaves like Upon close inspection, though, the authors are not examining the behavior of high-yield debt. Rather, they are studying the effect of high-yield debt issuance on the behavior of equity, which is an altogether different matter. Smith (1986) explains why a company's share price falls when it announces an offering.2 Investors assume that management has superior information about the company's prospects. They further assume that management is more likely to issue stock when the market price exceeds management's assessment of its value. Accordingly, investors interpret the announcement of an intention to issue as a sign that the market is overvaluing the company. They respond by revising their value estimates downward. Smith's argument would also explain why announcements of straight debt financing do not have a significant impact on stock prices. Just as it has an incentive to sell in a period of overvaluation, a company is understandably averse to selling that is undervalued (or fairly valued). Under such conditions, the company that happens to have a net requirement for external capital will probably issue debt, rather than equity. To investors, an announcement of a planned debt financing logically should not imply that management believes the stock to be overvalued. Investors therefore have no reason to revise their valuations downward. In short, it makes sense that debt announcements, unlike announcements, do not have a significant negative effect on stock prices. From the corporation's standpoint, the choice between issuing and issuing debt is ordinarily unaffected by its bond rating.3 (One possible exception is the case in which