The Leverage Changing Consequences of Convertible Debt Financing

Abstract

A convertible bond is a hybrid security. One component is like a straight bond, with regular interest payments and less downside risk than common stock. The other component is like common stock, giving the investor a claim on the residual earnings of the firm. Although convertible bonds are often categorized as straight debt, some convertibles may really be more like common stock. In fact, as Broman [1] documents, it is not uncommon for convertibles to be converted into common stock within a few years of issuance even though they would not mature for two or three decades. Therefore, if convertibles are primarily equity, their issuance can decrease financial leverage. Common stock price declines are associated with convertible debt issuance announcements. For 132 announcements of convertible offerings made between 1970 and 1979, Dann and Mikkelson [3] find an average two-day announcement period abnormal common stock return of 2.31% which is significantly different from zero at the 0.01 level. Eckbo [4], Hansen and Crutchley [6], and Mikkelson and Partch [8] document similar results. Dann and Mikkelson fail to find evidence in support of a number of theories they consider as possible explanations for these negative equity returns. One of these theories relates to information conveyed by a change in leverage. If convertible debt financing is leverage-increasing, negative announcement period returns are not consistent with the leverage hypothesis (i.e., the hypothesis that greater leverage increases firm value). This argument is used by Dann and Mikkelson to show that the leverage hypothesis is not a plausible explanation for announcement period common stock price behavior. This study examines whether convertible debt financing decreases a firm's financial leverage. By regressing convertible bond rates of return on common stock and straight debt rates of return, it is shown that This study is derived from my dissertation completed at Virginia Tech, Blacksburg, VA. I am grateful to Robert S. Hansen (Chairman), Arthur J. Keown, John M. Pinkerton, Dilip K. Shome, Bernard W. Taylor, and Walter L. Young for their valuable assistance in developing the ideas in this paper. I would also like to thank Robert A. Taggart of Financial Management as well as the anonymous reviewers.