Tax Options, Clienteles, and Adverse Selection: The Case of Convertible Exchangeable Preferred Stock

Abstract

Firms that issue convertible exchangeable preferred stock can later exchange it for debt with identical conversion and cash flow rights, thus capturing interest tax deductions when they can benefit from them. Despite tax and transaction-cost advantages, many issuers forego this innovative security in favor of otherwise identical, traditional convertible preferred stock. Tests of two potential explanations are presented, that issuers of the traditional security: specialize in serving an investor clientele that wants to avoid owning convertible bonds, or signal that they expect to force conversion into common equity earlier, implying a higher firm value. The evidence favors the clientele explanation.