Convertible Debt Research Articles

The Long-Run Performance Following Convertible Debt Offerings: Does The Design Matter?

<p>This paper examines the impact of convertible debt design on the long-run stock price performance of the issuing firms in France. More specifically, we divide French convertible bonds (CBs) into three categories; namely, debt-like, mixed, and equity-like CBs, based on their total conversion probability, which integrates the possibility of early exercise of the call feature. In line with previous empirical studies, our results show that French CB issuers experience a substantial increase in their stock price profitability before the offering followed by significant under-performance over the three year post-issue event window. However, the breakdown of our sample into three groups of CBs depending on their design reveals, on one hand, a strong evidence of stock price run-up before the offering only for equity-like and mixed CBs. On the other hand, the post-issue performance is worse only for equity-like issuers, indicating that the post-issue performance is poorer the more the convertible debt issuer's stock is over-valued prior to the offering. This finding is consistent with the market timing hypothesis.</p>

Corporate Postretirement Benefit Plans and Real Investment

This paper shows that the real investment by nonfinancial firms is systematically related to the size of their defined-benefit plan. In particular, these plans allow research and development (R&D)-intensive firms to retain and borrow from their employees, which is attractive since they have high adjustment costs, require a stable cash flow, have less collateral, have assets that are harder to value, and have high asymmetric information and agency costs. By contrast, capital expenditures benefit from credit multiplier effects with regard to regular debt, which substitutes for postretirement obligations. As a result, firms with defined-benefit plans have 12% more R&D and 5% less capital expenditure compared with otherwise similar firms, and they vary contributions as a function of cash flow and real investment. The role of postretirement plans is attenuated in countries with available alternative funding sources. The results are robust to controlling for other dimensions of financial policy—cash holdings, debt maturity, dividends, preferred stock, convertible debt, and leverage—that also affect real investment. This paper was accepted by Gustavo Manso, finance.

Foreign capital raising by Indian firms: An examination of domestic stock price response

We examine the domestic stock price response to foreign capital issuance by Indian firms. Firms have extensively used foreign equity and convertible foreign debt sources since 1994. The role of foreign investment bankers, size of the issue, firm's growth opportunities, and other factors are examined in the cross-sectional analysis of domestic stock price response. We find that firms experience positive stock price response to both equity and debt issues abroad, with greater response to issuance of American Depositary Receipts (ADRs), and financing high corporate growth.

Aligning Incentives at Systemically Important Financial Institutions: A Proposal by the Squam Lake Group

To address the moral hazard problem that can motivate bank executives to take excessive risks and to fail to raise capital when needed, a group of 13 distinguished financial economists recommends that systemically important financial institutions be required to issue contingent convertible debt (CoCos) and to hold back a substantial share—as much as 20%—of the compensation of employees who can have a meaningful impact on the survival of the firm. This holdback should be forfeited if the firm's capital ratio falls below a specified threshold. The deferral period should be long enough—the authors suggest five years—to allow much of the uncertainty about managers' activities to be resolved before the bonds mature. Except for forfeiture, the payoff on the bonds should not depend on the firm's performance, nor should managers be permitted to hedge the risk of forfeiture. The threshold for forfeiture should be crossed well before a firm violates its regulatory capital requirements and well before its contingent convertible securities convert into equity.The Swiss Bank UBS has paid bonuses to its top 6,500 executives that have been structured in exactly this way. Management forfeits its deferred compensation if the bank's regulatory capital ratio falls below 7.5%, and its contingent convertible debt is set up to convert into equity if the bank's capital ratio falls below 5%.

Hedge Fund Involvement in Convertible Securities

Convertible arbitrage hedge funds combine long positions in convertible securities with short positions in the underlying stock. In effect, hedge funds use their knowledge of the borrowing and short‐sale market to hedge themselves while distributing equity exposure to a large number of well‐diversified investors through their short positions.The authors argue that many “would‐be” equity issuers that would otherwise pay high costs in a secondary equity issue choose instead to issue convertible debt to hedge funds that in turn distribute equity exposure to institutional investors. This allows companies to receive “equity‐like” financing today at lower cost than a secondary equity offering. The authors' findings also suggest that more convertibles will be privately placed with hedge funds when issuer and market conditions suggest that shorting costs will be lower.

Contingent Capital, Tail Risk, and Debt-Induced Collapse

Contingent capital in the form of debt that converts to equity as a bank approaches financial distress offers a potential solution to the problem of banks that are too big to fail. This paper studies the design of contingent convertible bonds and their incentive effects in a structural model with endogenous default, debt rollover, and tail risk in the form of downward jumps in asset value. We show that once a firm issues contingent convertibles, the shareholders’ optimal bankruptcy boundary can be at one of two levels: a lower level with a lower default risk or a higher level at which default precedes conversion. An increase in the firm’s total debt load can move the firm from the first regime to the second, a phenomenon we call debt-induced collapse because it is accompanied by a sharp drop in equity value. We show that setting the contractual trigger for conversion sufficiently high avoids this hazard. With this condition in place, we investigate the effect of contingent capital and debt maturity on capital structure, debt overhang, and asset substitution. We also calibrate the model to past data on the largest U.S. bank holding companies to see what impact contingent convertible debt might have had under the conditions of the financial crisis.

Convertible debt and shareholder incentives

Given equity's convex payoff function, shareholders can transfer wealth from bondholders by increasing firm risk. We test the existing hypothesis that convertible debt reduces this classical agency problem of risk-shifting. First, we derive a measure of shareholders' risk incentives induced by convertible debt using a contingent claims framework. We then document that when risk-shifting incentives are high, the propensity to issue convertible (rather than straight) debt increases and the negative stock market reaction following convertible debt issue announcements is amplified. We further highlight that convertible debt is the only type of security that affects business risk durably downwards. Our conclusions support the agency theoretic rationale for convertible debt financing especially for financially distressed firms.

What we do and do not know about convertible bond financing

We review the literature on the issuance motives, shareholder wealth effects, and design of convertible bonds. Empirical studies on convertible debt issuance mainly focus on testing the predictions of four traditional theoretical models based on convertibles' potential to mitigate agency or adverse selection costs, and obtain mixed evidence. Recent studies on shareholder wealth effects of convertible bond issues highlight the need to control for arbitrage-related short selling and post-issuance risk changes. Studies on the determinants of convertible bond design uncover earnings management, as well as catering incentives to convertible arbitrage funds, as important determinants of innovations in convertible bond characteristics. Overall, our review indicates that recent empirical research on convertible debt provides valuable insights into issue motives and determinants of financial innovations, but also considers the broader question of how investor demand characteristics impact corporate finance decisions. We conclude with an overview of potential research questions to be addressed by future research on hybrid securities.

Do Investor Demand and Market Timing Affect Convertible Debt Issuance Decisions by REITs?

The unique regulatory environment of REITs casts doubt on the traditional theoretical process by which REIT managers base their convertible debt issuance decisions on issuer condition and prospects. Anecdotal evidence shows that REITs may have catered to demand by investors, including a demand by convertible bond arbitrageurs when issuing convertible debt. This study examines the rationale behind convertible debt issuances by REITs, focusing on the possible impacts of investor demand and market timing. The results suggest that investor demand significantly affects convertible debt issuance decisions by REITs while certain unknown factors appear to have contributed to the sudden increase of convertible debt offerings in 2006 and 2007. REITs also time the market to conditions in the public debt market. The results only partially support the offered risk-shifting, risk-uncertainty, backdoor-equity, and sequential-financing hypotheses.

CoCos, Bail-In, and Tail Risk

Contingent convertibles (CoCos) and bail-in debt for banks have been proposed as potential mechanisms to enhance financial stability. They function by converting to equity when a bank approaches insolvency. We develop a capital structure model to analyze the incentives created by these forms of contingent capital. Our formulation includes firm-specific and market-wide tail risk in the form of two types of jumps and leads to a tractable jump-diffusion model of the firm’s income and asset value. The firm’s liabilities include insured deposits and senior and subordinated debt, as well as convertible debt. Our model combines endogenous default, debt rollover, and jumps; these features are essential in examining how changes in capital structure to include CoCos or bail-in debt change incentives for equity holders. We derive closed-form expressions to value the firm and its liabilities, and we use these to investigate how CoCos affect debt overhang, asset substitution, the firm’s ability to absorb losses, the sensitivity of equity holders to various types of risk, and how these properties interact with the firm’s debt maturity profile, the tax treatment of CoCo coupons, and the pricing of deposit insurance. We examine the effects of varying the two main design features of CoCos, the conversion trigger and the conversion ratio, and we compare the effects of CoCos with the effects of reduced bankruptcy costs through orderly resolution. Across a wide set of considerations, we find that CoCos generally have positive incentive effects when the conversion trigger is not set too low. The need to roll over debt, the debt tax shield, and tail risk in the firm’s income and asset value have particular impact on the effects of CoCos. We also identify a phenomenon of debt-induced collapse that occurs when a firm issues CoCos and then takes on excessive additional debt: the added debt burden can induce equity holders to raise their default barrier above the conversion trigger, effectively changing CoCos to junior straight debt; equity value experiences a sudden drop at the point at which this occurs. Finally, we calibrate the model to past data on the largest U.S. bank holding companies to see what impact CoCos might have had on the financial crisis. We use the calibration to gauge the increase in loss absorbing capacity and the reduction in debt overhang costs resulting from CoCos. We also time approximate conversion dates for high and low conversion triggers.

Convertible debt and investment timing

In this paper we provide an investment-based explanation for the popularity of convertible debt. Specifically, we demonstrate the ability of convertible debt to alleviate and potentially totally eliminate the underinvestment problem of Myers (1977). A conversion feature induces shareholders to accelerate investment. This effect arises from the incentive of equity holders to accelerate the issuance of new equity, used to finance investment, since by investing early shareholders dilute the value of convertible debt holders by reducing their proportional claims to the firm's cash flows. Since the underinvestment effect and the accelerated investment effect work in opposite directions, convertible debt allows to mitigate or completely eliminate the debt overhang problem. In addition, we show that by choosing the right combination of straight debt and convertible debt, shareholders can, for a wide range of overall debt levels, commit to the investment strategy of an all-equity firm.

Does corporate governance influence convertible bond issuance?

We examine the influence of corporate governance quality on firms' choice between convertible debt, straight debt, and equity using a Western European sample of security offerings made between 2000 and 2010. We find that weaker firm-specific and country-specific corporate governance quality increases firms' likelihood of issuing convertible debt instead of straight debt and common equity. We also find that stockholder reactions to convertible debt announcements are more favorable for firms with weaker corporate governance. Our results suggest that corporate governance quality is a significant security choice determinant, with firms using convertible debt as a substitute for high quality governance mechanisms.

Cash-settled convertible bonds and the value relevance of their accounting treatment

Cash settlements became a popular design feature in convertible securities once they obtained favorable accounting treatment for diluted earnings per share in 2002. The unexpected proliferation of cash settlements provoked the FASB to eliminate their favorable accounting treatment in 2008. We find that shareholders of firms that use cash-settled convertibles react negatively to the announcement of these recent changes. Firms that issued cash-settled convertible debt to avoid earnings dilution no longer have an incentive to keep them on their balance sheets. Consistent with this observation, we find that investors respond more favorably if the cash-settled convertibles of these firms include call features. We conclude that call features can be valuable in times of uncertainty related to possible accounting changes as they allow the firm to efficiently mitigate the effects of the accounting changes on their financial reporting.

How to Design a Contingent Convertible Debt Requirement That Helps Solve Our Too‐Big‐to‐Fail Problem*

As bank regulatory reform tries to come to grips with the lessons of the financial crisis, several experts have proposed that some form of contingent convertible debt (CoCo) requirement be added to the prudential regulatory toolkit. In this article, the authors show how properly designed CoCos can be used not just to absorb losses, but more importantly to encourage banks to recognize losses and replace lost equity in a timely way, as well as to manage risk more effectively. Their proposed CoCos requirement strengthens management's incentives to promptly replace lost capital and enhance risk management by imposing major costs on the managers and existing shareholders of banks that fail to do so.Key elements of the proposal are that conversion of the CoCos into equity would be (1) triggered at a high trigger ratio of equity to assets (long before the bank is near an insolvency point), (2) determined by a market trigger (using a 90‐day moving average market equity ratio) rather than by supervisory discretion, and (3) significantly dilutive to shareholders. The only clear way for bank managements to avoid such dilution would be to issue equity into the market.Under most circumstances—barring an extremely rapid plunge of a bank's financial condition—management should be able and eager to replace lost capital in a timely way; as a result, dilutive conversions should almost never occur. Banks would face strong incentives to maintain high ratios of true economic capital relative to risky assets, and to manage their risks effectively. This implies that “too‐big‐to‐fail” financial institutions would not be permitted to approach the point of insolvency; they would face strong incentives to recapitalize long before that point. And if they should fail to issue new equity in a timely manner, the CoCos conversion would provide an alternative means of recapitalizing banks well before they reach the brink of insolvency. Thus, a CoCos requirement would go a long way to resolving the “too‐big‐to‐fail” problem.Such a CoCos requirement would not only increase the effectiveness of regulation, but also reduce its cost. It would be less costly for banks to raise CoCos than equity, reflecting both the lower adverseselection costs of CoCos issuance and the potential tax advantages of debt. And precisely because of the low probability of CoCo conversion, the Cocos would be issued at relatively modest (if any) discounts to otherwise comparable but straight subordinated debt. Thus requiring a mix of equity and appropriately designed CoCos would be less costly to banks, and would entail less of a reduction in the supply of loans than would a much higher book equity requirement alone.

Does CEO-Specific Performance Impact Corporate Decisions? Evidence from Convertible Debt Issues

A firm’s convertible debt issues are not only determined by the fundamentals of the firm such as past stock performance, but also related to whether this performance is realized during the tenure of current CEO who decides the issues. I define the performance that the current CEO achieves in the firm ever since the CEO comes to the helm as CEO-specific performance. Higher CEO-specific performance leads to (1) a higher probability of convertible issues, and (2) a less negative abnormal stock return in response to the convertible issue announcements, controlling for other firm characteristics. These evidences show that CEO-specific performance serves as a credible information signal to influence the adverse selection costs between the firm and outside investors in convertible debt financing.

Convertible Debt and Investment Timing

In this paper we provide an investment-based explanation for the popularity of convertible debt. Speci fically, we demonstrate the ability of convertible debt to alleviate and potentially totally eliminate the underinvestment problem of Myers (1977). A conversion feature induces shareholders to accelerate investment. This e ffect arises from the incentive of equity holders to accelerate the issuance of new equity, used to fi nance investment, since by investing early shareholders dilute the value of convertible debt holders by reducing their proportional claims to the fi rm's cash flows.Since the underinvestment eff ect and the accelerated investment e ffect work in opposite directions, convertible debt allows to mitigate or completely eliminate the debt overhang problem. In addition, we show that by choosing the right combination of straight and convertible debt, shareholders can, for a wide range of overall debt levels, commit to the investment strategy of an all-equity firm.

Convertible Debt and Shareholder Incentives

Given equity’s convex payoff function, shareholders can transfer wealth from bondholders by increasing firm risk. We test the existing hypothesis that convertible debt reduces this classical agency problem of risk-shifting. First, we derive a measure of shareholders’ risk incentives induced by convertible debt using a contingent claims framework. We then document that when risk-shifting incentives are high, the propensity to issue convertible (rather than straight) debt increases and the negative stock market reaction following convertible debt issue announcements is amplified. We further highlight that convertible debt is the only type of security that affects business risk durably downwards. Our conclusions support the agency theoretic rationale for convertible debt financing especially for financially distressed firms.

Contingent Capital with a Capital-Ratio Trigger

Contingent capital in the form of debt that converts to equity when a bank faces financial distress has been proposed as a mechanism to enhance financial stability and avoid costly government rescues. Specific proposals vary in their choice of conversion trigger and conversion mechanism. We analyze the case of contingent capital with a capital-ratio trigger and partial and ongoing conversion. The capital ratio we use is based on accounting or book values to approximate the regulatory ratios that determine capital requirements for banks. The conversion process is partial and ongoing in the sense that each time a bank's capital ratio reaches the minimum threshold, just enough debt is converted to equity to meet the capital requirement, so long as the contingent capital has not been depleted. We derive closed-form expressions for the market value of such securities when the firm's asset value is modeled as geometric Brownian motion, and from these we get formulas for the fair yield spread on the convertible debt. A key step in the analysis is an explicit expression for the fraction of equity held by the original shareholders and the fraction held by converted investors in the contingent capital. This paper was accepted by Gérard P. Cachon, stochastic models and simulation.

Pitfalls in Levering and Unlevering Beta and Cost of Capital Estimates in DCF Valuations1

The “levering” and “unlevering” of estimates of beta and various costs of capital are routine steps in estimating the discount rates used in DCF valuations. But as the authors demonstrate by reviewing the existing research on the subject, the levering and unlevering formulas that are most commonly used in practice are not appropriate for valuing many companies. They also illustrate the shortcomings of—and substantial valuation errors that can result from—the common practices of assuming that the betas of securities like debt and preferred stock are equal to zero and ignoring the effects of equity‐linked securities such as employee stock options, warrants, and convertible debt.The authors offer alternative levering formulas that are more appropriate for valuing most companies than—and as readily implemented as—the formulas commonly used today. They also provide a relatively easy way to estimate betas for debt and preferred stock that can be used in the levering and unlevering formulas. The authors discuss how properly to account for equity‐linked securities such as employee stock options, warrants, and convertible debt while demonstrating the potential importance of ignoring such equity‐linked securities in the levering and unlevering formulas. Finally, the authors show why it is appropriate to standardize the treatment of contractual obligations such as leases across comparable companies in order to get consistent estimates of the unlevered cost of capital.

Signaling with Convertible Debt in High-Risk Industries

This paper analyzes how convertible debt is used in a high-risk, emerging industry setting. We argue that there is a lifecycle component to the design and market impact of convertible debt securities. Contrary to prior cross-industry research findings, we show that convertible debt in the renewable energy industry tends to have a debt-like structure, and its issue is associated with strongly nega¬tive announce¬ment returns. We further show that convertible issuers face high adverse selection costs, which they attempt to mitigate by sending signals about firm quality. However, these signals tend to fail because the market anticipates this behavior, and perceives convertible issuers as being priced out of the equity markets. Firm and industry characteristics support this view, because financial distress indicators suggest the use of more equity-like financing instruments.