What is Wrong with Convertible Bonds that Provide Call Options to Third Parties?

Abstract

Callable convertible bonds (CBs) that provide call options to third parties but are not used in major economies have been issued since issuances of detachable privately placed bonds with warrants (BWs) were banned in 2013. The largest shareholders prefer callable CBs to detachable BWs as they are purchased only if call options are in the money. This study analyses the effect of call options on the announcement effects of CB issuances and conversion right exercises using 1,496 privately placed CBs issued between 2013 and 2018. The major findings are as follows. First, the announcement effects of callable CBs are significantly smaller than those of standard CBs, which indicates that providing call options to third parties is viewed negatively. Second, callable CB issuing firms have better operating performance, higher ownership of the largest shareholders, and a higher adoption rate of refixing clauses than standard CB issuing firms. Third, the announcement effects of exercising conversion rights are significantly negative and those of callable CBs are significantly more negative than those of standard CBs. In summary, the results highlight the structural problems of callable CBs and provide empirical evidence to support our hypothesis. We recommend that financial authorities ban the issuance of callable CBs.