Convertible debt
Is Convertible Debt a Substitute for Straight Debt or for Common Equity?
Craig M. Lewis
Owen Graduate School of Management
Vanderbilt University
Nashville, TN 37203
Richard J. Rogalski
Amos Tuck School of Business
Dartmouth College
Hanover, NH 03755
James K. Seward
Graduate School of Business
University of Wisconsin-Madison
Madison, WI 53706
August 1999
*The authors thank Kooyul Jung, Yong-Cheol Kim and Rene Stulz for providing their equity and debt security offer data set. They also thank seminar participants at Miami, Vanderbilt and
Wisconsin, the 1999 American Finance Association Meeting, the 1999 European Finance
Management Association meeting,; especially Espen Eckbo, Wayne Mikkelson, David Parsley and
Hans Stoll for their helpful comments. Sarah Leonard provided expert data management assistance. Abstract
This paper examines the ability of the risk-shifting hypothesis and the backdoor equity hypothesis to explain firms’ decisions to issue convertible debt. Using a security choice model that incorporates pre-offer issue, issuer, and macroeconomic information, we document significant variation in the market reaction to new convertible debt issues depending on whether investors expect the motivation for issuance to be asset substitution or asymmetric information. Our results suggest that both motives explain the use and design of convertible debt. Some firms issue convertible debt instead of straight debt to mitigate the costs of bondholder/stockholder agency conflicts. Other issuers use convertible debt instead of common equity to reduce the costs of adverse selection. Thus, in contrast to standard securities like straight debt or common equity, which solve some financing problems but exacerbate others, hybrid securities such as convertible debt are seen as providing a more flexible funding choice that can solve conflicting financing problems. Financial economists study the security issue decision to understand more
Craig M. Lewis
Owen Graduate School of Management
Vanderbilt University
Nashville, TN 37203
Richard J. Rogalski
Amos Tuck School of Business
Dartmouth College
Hanover, NH 03755
James K. Seward
Graduate School of Business
University of Wisconsin-Madison
Madison, WI 53706
August 1999
*The authors thank Kooyul Jung, Yong-Cheol Kim and Rene Stulz for providing their equity and debt security offer data set. They also thank seminar participants at Miami, Vanderbilt and
Wisconsin, the 1999 American Finance Association Meeting, the 1999 European Finance
Management Association meeting,; especially Espen Eckbo, Wayne Mikkelson, David Parsley and
Hans Stoll for their helpful comments. Sarah Leonard provided expert data management assistance. Abstract
This paper examines the ability of the risk-shifting hypothesis and the backdoor equity hypothesis to explain firms’ decisions to issue convertible debt. Using a security choice model that incorporates pre-offer issue, issuer, and macroeconomic information, we document significant variation in the market reaction to new convertible debt issues depending on whether investors expect the motivation for issuance to be asset substitution or asymmetric information. Our results suggest that both motives explain the use and design of convertible debt. Some firms issue convertible debt instead of straight debt to mitigate the costs of bondholder/stockholder agency conflicts. Other issuers use convertible debt instead of common equity to reduce the costs of adverse selection. Thus, in contrast to standard securities like straight debt or common equity, which solve some financing problems but exacerbate others, hybrid securities such as convertible debt are seen as providing a more flexible funding choice that can solve conflicting financing problems. Financial economists study the security issue decision to understand more
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