Convertible Bond Issuance, Risk, and Firm Financial Policy: A New Approach

I. INTRODUCTION Convertible bonds ('CBs' hereinafter) are hybrid securities with both debt and equity features, and have served as a major source of financing for firms over the past two decades. According to SDC data, from 1995 to 2006, the total value of CB issues increased in the US by 581.60%. Over this period, the ratio of CB financing to equity financing expanded from 10.15% to 36.75%. The popularity of CBs appears puzzling from a number of perspectives. First, establishing a fair price for any particular CB is complex, due to its long-term option-like characteristics. CBs are typically embedded with interacting indenture components that may not respond uniformly to expected or unexpected events. Consequently, it is still a challenge to 'correctly' price CBs for both issuers and investors. CBs, as complex financial instruments for problems related to financing and investment are not consistent with the Principle of Ockham's Razor. (1) Why do firms issue CBs and do investors find them attractive? The purpose of this paper is to develop a theoretical model to address these issues. Researchers have identified several justifications for CB issuance including: providing lower cost financing relative to straight bonds or pure equity financing, dealing with asymmetric information, tax benefits, risk mitigation benefits, as well as agency benefits (e.g., Jensen and Meckling, 1976; Green, 1984; Brennan and Schwartz 1988; Stein, 1992; Jalan and Barone-Adesi, 1995; Isagawa, 2000 and 2002; Loncarski, Horst, and Veld, 2006a). Counterbalancing these benefits of CBs are various potential costs, however. (2) CBs could be more expensive than either pure equity or straight debt financing, given the firm's ex ante prospects. For example, if a firm projects some likelihood of poor performance ex ante, CBs might not be converted. And issuers may be forced to redeem CBs when their cash flow is already under pressure. Firms on the verge of financial distress will encounter further difficulties in their future financing plans as a consequence of CB investor disappointment. Managers put at risk both their personal portfolios invested in the firm and their reputation for their future careers. In this scenario, issuers could be better off if they had chosen equity financing instead. On the other hand, if the management is certain about the favourable prospects of their new projects, it could be cheaper for them to use some other form of financing besides convertibles. Specifically, they could issue regular corporate bonds at the initial financing stage for the new project, then wait until the stock price rises to reflect the benefits of the project, and then finance with equity. We refer to this alternative (straight debt followed by straight equity) serial financing plan as AP henceforth. Additionally, CB financing introduces an element of uncertainty to the firm's cash flow and future financing requirements due to the uncertain nature of investor holding periods over longer horizons. Firms with a large overhang of unconverted CB's often face difficulties when they must resort to capital markets for subsequent financing. Empirically, the conversion process of CBs is slow (e.g., Ederington, Caton and Campbell, 1997; Byrd, Mann, Moore and Ramanlal, 1998). Several empirical studies show that the price of CBs has to stay well above the conversion price for a considerable period of time before issuers use their call rights to force investors to exercise their CBs. It appears that issuers do not deploy theoretically optimal call strategies, such as that of Brennan and Schwartz (1977a): "call the bond as soon as the value of the bond if called is equal to the value if not called. " Suboptimal call policies can be attributed to a number of factors: 1) management wants CBs to be converted into equity, 2) financial stress could show up if CBs are called too early, and 3) to call is a bad signal for the issuer. …