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This study resolves the puzzling evidence on convertible bonds by documenting that conversion-forcing calls are indeed bad news. Supporting the long-term implications of Harris and Raviv (1985), we document that the common stocks of calling firms substantially underperform their benchmarks by a median of 64% over the five-year post-call period. In contrast, firms that choose not to call their in-the-money convertibles exhibit no long-run abnormal performance. We show that studies drawing conclusions based on short-term price reversal immediately following the call fail to completely capture the valuation effect that occurs over a longer time horizon. We document that the market condition at the time of the call (issuance volume) and cash flow benefits related to the call (relation between dividend and after tax coupon payment) influence the post-call stock price performance. Our analysis also reveals that the post-call underperformance of high-growth firms is more pronounced than that of low-growth firms, indicating greater market exuberance associated with high-growth firms at the time of the call.
When a company calls its convertible bonds, it typically must give the convertible bondholders a notice period of approximately 30 days to decide whether to convert the bonds. This important institutional detail substantially affects the optimal call policy for convertible bonds. When the company calls the bonds, it fixes the price at which bondholders can redeem them, effectively giving bondholders a 30-day put option. The optimal time to call the convertibles minimizes the value of the conversion option net of the put option. This optimization problem is solved here, and a simple decision rule for the company results. This solution contains those of previous researchers as a special case.
We test and reject the hypothesis that managers call in-the-money convertibles when they view a decline in the value of the firm as likely. Inconsistent with this view, we find that insiders generally buy equity before conversion-forcing calls. Also, analysts tend to raise their earnings forecasts following a call. Thus, our evidence supports the alternative hypothesis that the price decline immediately following conversion-forcing calls is a purely transitory decline caused by the anticipated increase in the supply of equity. Indeed, our evidence confirms that the initial price decline is reversed in the weeks following the announcement.
This study examines the wealth effects of convertible bond call announcements on stockholders, straight bondholders, called and non-called convertible debtholders. We document that forced conversions are associated with a significant loss in firm value. The results suggest that convertible call announcements can trigger both negative signal and wealth transfer effects. We show that at least part of the negative effect on stock prices results from wealth transfer to straight bondholders. Our analysis also lends empirical validity to the common contention that called convertible bondholders suffer wealth expropriation due to the elimination of the premium. The wealth effect on non-called convertible debtholders is insignificant. Cross-sectional analysis reveals that the negative signal effect is important in explaining bond, stock and firm excess returns. Finally, we present evidence that refutes the notion that bonds are called to relieve the firm from restrictive debt covenants.
Negative stock price reactions to conversion-forcing calls of convertible bonds and preferred stocks are re-examined, and most of the sample firms are shown to exhibit full price recovery by the end of the conversion period. In addition, analysts' earnings forecasts, both short-term and long-term, are found to be revised upward following call announcements for convertible bonds and preferred stocks. The combined findings cast doubt on the established belief that such capital structure decisions signal negative information about firm value.
We analyze callable, convertible, and callable-convertible bonds in a dynamic model with restructuring, taxation, and transaction/bankruptcy costs. In this setting, calling when conversion value equals call price is not generally optimal. Late (early) calls are optimal when the conversion ratio is high (low) and the debt coupon is low (high). If volatility is fixed, pure callable bonds with a substantial call premium maximize firm value, committing equity to second-best restructuring policies. Convertibles are dominated in this context, since the backdoor equity component of the bond is tax-inefficient. The model is extended to allow for instantaneous risk shifting. Call provisions shorten effective maturity, but are not sufficient to induce hedging. Convertible bonds induce hedging, and the optimal conversion ratio trades off incentive provision against tax costs. Convertibles dominate pure callable bonds only when costs of risk shifting are sufficiently high. Although they mitigate risk shifting incentives, no convertible bond can induce global hedging, since equity is infinitely risk loving near default. In addition, convertible bonds exacerbate underinvestment incentives, since conversion privileges reduce marginal q.