On financing with convertible debt over the last two decades

Despite extensive research, the rationale behind firms' decision to issue convertible debt is still unknown. On average, results indicate that the market reacts more negatively to new convertible debt issues of companies with higher cash ratios. Hence, I test whether convertible issuers are companies with limited access to the debt and equity markets. I find that pre-1990 issuers have a propensity to accumulate cash out of their cash flows prior to the convertible debt issue. Moreover, I provide strong evidence that convertible issuers substitute cash for both short-term debt and non-cash net working capital. I also test the pricing of new convertible debt securities at issue. I use a 100-step trinomial tree and find that convertible bonds are issued at an average discount 4.84 from their fair market value. Although the discount appears to be slightly higher in the pre-1990 period than the post-1990 period, the difference is not statistically significant. I also test for the determinants of the degree of underpricing of new convertible debt securities. I find that longer maturity issues and issues with higher coupon rates are more underpriced in the pre-1990 period. I attribute this finding to the poor stock and bond markets of the early and mid 1980s, which caused investors to become weary about long-term fixed income instruments. I find that longer maturity issues are less underpriced in the post-1990 period. This is probably because the value of the conversion option increases with maturity. Furthermore, it appears that issues with higher coupon rates and lower conversion premiums are less underpriced. I attribute this finding to investors being more informed in the post-1990 period and, therefore, less willing to accept higher conversion premiums. I also show that cash redemptions of convertible debt securities are not associated with a negative market reaction, even though forced conversions result in an abnormal negative return at the time of the announcement. Contrary to previous arguments by Stein (1992) and Moody's, I find no evidence that companies force conversion of their securities in order to avoid future bankruptcy.