Convertible bonds are bonds that can be converted into equity at the option of the investor. Convertibles are an important source of finance for U.S. firms: U.S. convertible debt issuance amounted to $61.6 billion in 2007, compared with $71.8 million raised from seasoned equity offerings and $388.5 million from straight debt issues.
The literature provides several theoretical motivations for convertible debt issuance. Due to the asymmetric nature of their payoffs, convertibles can mitigate agency problems (Green, 1984), provide an alternative to equity when information asymmetry regarding future returns is high (Stein, 1992), and substitute for debt when there is increased uncertainty about the riskiness of returns (Brennan and Schwartz, 1988).
Consistent with these explanations, Lewis et al. (1999, 2003) find that convertible debt issuers have high costs of attracting standard financing types. Other papers find that firms are more likely to issue convertibles during periods with higher debt- and equity-related contracting costs (Hoffmeister et al., 1987; Mann et al., 1999; Krishnaswami and Yaman 2007b).
In this paper we hypothesize that, next to firm-specific and general debt and equity-related variables, convertible debt issuance might also be driven by investor demand for convertible securities. We follow a recent strand of literature that examines how corporate decisions are influenced by demand forces in the market (see for example Baker and Wurgler, 2004; Baker et al., 2007; Polk and Sapienza, 2008). As an asset class, convertible bonds are different from equities or straight debt since they allow the holder to benefit from upside movements in stock prices, while being less affected by downward movements due to their debt component. Lummer and Riepe (1993) and Eckmann et al. (2007) offer several reasons why convertibles should be considered as a separate asset class and not one whose payoffs can be easily replicated, while Ammann et al. (2007) empirically show that the return process of convertible bond funds cannot be fully explained by factors typically related to stock and bond markets. We argue that investor preferences for these typical convertible-debt related features fluctuates over time, and that companies issue convertibles to satisfy this investor appetite. Evidence that investor appetite for convertibles varies over time can also be found in the popular press.
Download
Do Convertible Bond Issuers Cater to Investor Demand?
