The Role of Convertible Bonds in Alleviating Contracting Costs

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Abstract
We examine the impact of macroeconomic and firm-specific factors on the likelihood of issuance and the structure of convertible bonds. Consistent with convertibles mitigating financial distress and contracting costs, our results indicate that the likelihood of issuing convertible bonds compared to straight bonds is higher for smaller firms, high growth firms, firms with high levels of information asymmetry, and firms with high bankruptcy costs. We also find that firms are more likely to issue convertibles during periods of high interest rates, and during industry and economic downturns - periods when bankruptcy and financial distress costs are higher, and investment opportunities and agency problems deteriorate. When we examine the variation in the ex-ante probability of conversion of convertibles, we find that this probability is higher (i.e., convertible bonds are more equity-like) for smaller firms and during periods of high interest rates. Since financial distress costs are high in these cases, issuing equity-like convertibles allows firms to mitigate these costs by reducing their fixed claims. We also find that the convertibles are structured to be more equity-like in firms with low firm-specific information asymmetry, and during periods of high economic growth. Overall, convertible bonds provide firms an element of flexibility over straight bonds and equity that allow firms to mitigate financial distress and contracting costs of moral hazard and adverse selection, and raise capital even during unfavorable conditions. However, we find that financially constrained firms are less able to exploit the flexibility provided by convertibles as their need for capital overshadows all other concerns.

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