Is Convertible Debt a Substitute for Straight Debt or for Common Equity?

Financial Management (Financial Management Association), Autumn, 1999 by Craig M. Lewis, Richard J. Rogalski, James K. Seward

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 issue convertible debt instead of common equity to reduce the costs of adverse selection.

Financial economists study the security-issue decision to understand more fully why firms choose to issue a particular security and how investors in the financial markets react to that choice. The research documents several results about investor reaction to the announcement of convertible debt security offers. First, price reactions to convertible debt security offer announcements are negative and statistically significant. Second, the average price reaction to convertible debt security offer announcements lies between the average price reactions to common equity and straight debt security offer announcements. Since existing research has been unsuccessful in identifying factors that explain these announcement period results, there is little definitive empirical evidence that explains either the convertible-debt-issuance decision or investor reactions to the issuance decision.

The purpose of this paper is twofold. The first is an examination of the decision to raise capital using a hybrid security like convertible debt rather than a standard security like straight debt or common equity. Existing research suggests that the choice between straight debt and common equity is partially predictable. We extend this literature by proposing and implementing a security choice model that includes nonstandard security choices like convertible debt. Our results indicate that preoffer issue, issuer, and macroeconomic information can reliably explain issue choices.

Our second objective is to reexamine the information content of convertible debt security offer announcements. This is important because, even though existing studies have demonstrated a significantly negative stock price reaction to convertible debt offerings (Dann and Mikkelson, 1984; and Eckbo, 1986), they fail to document a significant cross-sectional relation between excess returns and firm specific explanatory variables. Recent research suggests that investor reaction to straight debt announcements can be explained by the partial anticipation of the offer (see, Chaplinsky and Hansen, 1993; and Jung, Kim, and Stulz, 1996). We show that the preoffer information that conditions investor expectations of a convertible debt offer also enhances the explanatory power of the cross-sectional analysis of announcement period excess returns.

Several theoretical explanations have been proposed to explain the use of convertible debt and investor reaction to that security offer choice. Green (1984) demonstrates that the substitution of convertible debt for straight debt reduces the agency costs that are caused by bondholder/stockholder conflicts of interest. This theory is known as the "risk-shifting" hypothesis. [1] Stein (1992) argues instead that corporations use convertible debt as a substitute for common equity because it provides indirect equity financing that mitigates the adverse selection costs associated with direct equity offerings. This theory is known as the "backdoor-equity" hypothesis. [2]

These two theories make different empirical predictions about issuer motives that are based on the relative levels, and the specific sources, of debt-and equity-related financing costs. According to the risk-shifting hypothesis, issuers would prefer convertible debt issues to straight debt because they face high bondholder/stockholder agency costs. The theory does not identify an explicit source of equity-related financing costs. Therefore, after controlling for investors' expectations regarding the likelihood that an issuer will offer a debt-like security, the risk-shifting hypothesis predicts that convertible debt issuers will have significantly higher agency costs than straight debt issuers. [3]

The backdoor-equity hypothesis by contrast suggests that issuers prefer convertible debt issues to common equity because they face high adverse selection and financial distress costs. After controlling for investors' expectations regarding the likelihood that an issuer will offer an equity-like security, the backdoor-equity hypothesis predicts that convertible debt issuers will have significantly higher adverse selection and financial distress costs than issuers of equity. [4]

Prior research demonstrates that security offer choice decision models can explain an issuer's choice between standard securities like straight debt and common equity. To directly test the hypothesis that convertible debt can be viewed as either a straight debt substitute (as predicted by the risk-shifting hypothesis) or as a common equity substitute (as predicted by the backdoor-equity hypothesis), we build on the security choice model reported in Jung, Kim, and Stulz (1996). They estimate several logistic regression models that predict the type of security a firm is likely to issue (straight debt or common equity). The model assigns a probability that a particular firm issues straight debt or common equity.