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The signaling effects associated with convertible debt design
Journal of Business Research 62 (2009) 1358–1363
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Journal of Business Research
The signaling effects associated with convertible debt design Mookwon Jung a, Michael J. Sullivan b,⁎ a b
School of Business Administration, Kookmin University, Seoul, Republic of Korea College of Business, University of Nevada Las Vegas, Las Vegas, NV 89154-6008, United States
a r t i c l e
i n f o
Article history: Received 15 February 2008 Accepted 5 November 2008 Jel classifications: G14 G32
a b s t r a c t In this paper we investigate whether the terms used in the design of a convertible debt issue act as a signal of the issuing firm's future growth prospects. Our general premise is that convertible debt design terms are interrelated and arranged in a manner that signals asymmetric information to market participants. Empirical tests support our hypothesis, even after controlling for risk, firm size, time-to-maturity, and industry effects. Firms issuing convertible debt that arrange terms to take advantage of relatively better future growth prospects are found to have a relatively lower negative price reaction around the announcement of the offer. © 2008 Elsevier Inc. All rights reserved.
Keywords: Market efficiency Convertible debt Asymmetric information Signaling
Managers raise funds through issues of debt, equity, and through hybrid securities, such as, convertible debt. As such, managers of some firms find that issuing convertible debt is a more efficient means of raising funds (Green, 1984; Hoffmeister et al., 1987; Stein, 1992; Mayers, 1998). Brennan and Schwartz (1981), Kim (1990), and Mann et al. (1999) demonstrate that due to the risk-neutralizing effect of convertible debt and its role in reducing the underinvestment problem, convertible debt is an especially useful financing tool for high-risk, high-growth firms. Empirically, it has been shown that investors react negatively to the announcement of an issue of convertible debt, but that this market reaction may vary based on an accompanying signal of asymmetric information (Dann and Mikkelson, 1984; Myers and Majluf, 1984; Eckbo, 1986; Mikkelson and Partch, 1986; Hansen and Crutchley, 1990; Marciukaityte and Varma, 2007). Lewis et al. (2003) and Davidson et al. (1995) demonstrate that announcement period returns depend on the design of a convertible debt issue and argue that convertible debt issues that are more ‘equity-like’ suffer greater negative announcement market reactions. Our paper is based on this argument that design features of a convertible debt issue signal information about the issuing firm, specifically regarding future growth prospects. Davidson et al. (1995)
⁎ Corresponding author. Tel.: +1 702 895 4669. E-mail addresses: [email protected] (M. Jung), [email protected] (M.J. Sullivan). 0148-2963/$ – see front matter © 2008 Elsevier Inc. All rights reserved. doi:10.1016/j.jbusres.2008.11.002
create a model to estimate the expected time for a convertible bond to be at-the-money that is based on the conversion price and a priori growth expectations. In a similar manner, we derive a proxy of growth prospects that is based on the design terms of an announced convertible debt issue. Therefore, whereas Davidson et al. (1995) assume a growth rate to estimate the time for a convertible bond to be at-the-money, we make an assumption of at-the-money time to estimate growth. We argue that the pertinent signal provided the market through the terms of an announced convertible issue pertains to growth, which our model estimates directly. Therefore, if managers arrange terms of a convertible debt issue predicated on their asymmetric information of a firm's future growth prospects, and investors can discern this information, this information will be reflected in the stock price reaction at the offer announcement. Our findings offer support for this argument. Higher growth firms are found to have significantly less negative announcement returns than relatively lower growth firms. In addition, we find our growth estimate is robust across various assumed times for the issue to be at-the-money. A robustness check using analysts' long-term growth forecasts to proxy for future growth also supports our findings. The rest of this paper is organized as follows. We describe our growth proxy measure and primary hypothesis in Section 1. Section 2 describes the sample selection and provides descriptive statistics. Section 3 describes how we calculate our growth proxy, which we refer to as unanticipated growth. Section 4 demonstrates the signaling role of this unanticipated growth through an investigation of its relationship to the market reaction around the convertible debt issue announcement. Our conclusions are presented in Section 5.
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1. Growth proxy
Table 1 Summary Statistics for 790 Convertible Debt Issues from 1985-2003.
Convertible debt design involves various terms, such as, issue size, maturity, coupon rate, call features, conversion premium, and the conversion ratio. If there is an interrelationship between convertible debt offer terms and these terms are set considering the firm's future growth prospects, asymmetric information regarding these future growth prospects may be signaled to the market. Therefore, drawing from the work of Green (1984), Kim (1990), Stein (1992), Davidson et al. (1995), Munro (1996), Mayers (1998), and Lewis et al. (1998, 1999, 2003), we utilize design terms of convertible debt issues to derive a measure of implied growth. Specifically, our implied growth measure incorporates yield advantage, conversion premium, and an assumed time for a convertible debt issue to be atthe-money. The question we aim to answer using this growth proxy is whether convertible debt design signals asymmetric information regarding a firm's future growth prospects. Similar to Lewis et al. (1998, 2003) we also use the design terms of a convertible debt offer, but instead of sorting convertible debt offers into types, we use these terms to derive a proxy of an issuer's growth prospects. Our proxy for growth incorporates yield advantage, conversion premium, and an assumed time for the issue to be atthe-money. We define yield advantage as the difference between a firm's convertible debt yield and the yield of a comparable issue of straight debt, and conversion premium as the percentage by which the conversion price is higher than the stock price at the convertible debt offer date. Both yield advantage and conversion premium depend directly on growth prospects. Therefore, if we set the time for a convertible bond to be at-the-money, an estimated growth rate can be estimated and interpreted as the adjusted conversion premium where the adjustment is by yield advantage. We then estimate the change in growth prospects, which we refer to as unanticipated growth, by taking our measure of the implied future growth relative to a benchmark historic growth rate. This brings us to our primary hypothesis, that investors will reassess a firm's growth prospects based on information gleaned from design terms of a convertible bond offer. Therefore, we hypothesize that firms perceived to have higher (lower) growth prospects will be subject to a better (worse) price reaction at the announcement of the convertible debt issue.
Description
Mean
Median
Obs
Issue size ($ Mil) Relative issue value Relative issue amount Conversion premium Call protection Bond maturity (years) Debt ratio before offering Debt ratio after offering Three-day cumulative abnormal return (%)
182.54 0.43 0.22 24.12 3.16 15.12 0.22 0.36 −2.49
100.00 0.24 0.12 22.83 3.00 14.98 0.17 0.33 −1.97
790 527 527 790 718 790 520 520 770
2. Sample selection and descriptive statistics Data for our sample of convertible debt issues and a matched set of straight debt issues are obtained from the Thomson Financial Securities Database and the Fixed Income Securities Database provided by LJS Global Information Services Incorporated (The Fixed Income Securities Database data was obtained through the Fixed Income Research Program at the University of Houston, Bauer College of Business). We confirm all announcement dates using the Wall Street Journal. From the analysis we exclude American depositary receipts, foreign companies, asset-backed securities, warrants, firms without the necessary information on the CRSP Datatapes, and issues where information on conversion premium and yield-to-maturity are not available. The remaining sample includes 790 convertible debt issues from the 1985–2003 period. Table 1 provides summary statistics describing our sample. Compared to a sample of convertible debt issues studied by Lewis et al. (1998, 2003) for the period 1978 to 1992, our sample averages a larger issue size and longer maturity. We attribute these differences to the time periods studied. Otherwise, the samples are comparable. Announcement period returns are calculated for the three-day period ending on the announcement date for the convertible debt offerings using the Brown and Warner (1985) methodology (We use a three-day announcement window because of a possible one-day lag between the issue decision and the formal announcement and because the issue announcement may occur after the market close). We find these announcement period
Issue size is stated in millions of dollars. Relative issue value is defined as the issue size divided by the market value of firm's common stock for the fiscal year-end prior to the issue announcement date. Relative issue amount is defined as the number of shares that can be issued upon conversion divided by the number of shares outstanding for the fiscal year-end prior to the issue announcement date. The conversion premium is the conversion price divided by the market price of common stock the day prior to the issue announcement date. Call protection is the number of years before the convertible issue can first be called. Bond maturity is stated in years. Debt ratio before offering is calculated as the book value of debt divided by the sum of the book value of debt plus the market value of common stock, where the debt ratio after offering is measured at the time of offering as if conversion is assumed to occur at that time. The three-day cumulative abnormal return is from day − 2 to 0 relative to the first public announcement and is significantly different from zero at a 1% level (t-statistic= −8.73).
returns average −2.49% (t-statistic = −8.73). This announcement effect is similar in size and scale to that found by Dann and Mikkelson (1984), Mikkelson and Partch (1986), Hansen and Crutchley (1990), Pilotte (1992), Davidson et al. (1995), Datta and Iskandar-Datta (1996), Jen et al. (1997), and Lewis et al. (1998, 1999, 2003). In Table 2 we present distributional characteristics of our sample of convertible debt issues for yield-to-maturity (YTM), time-to-maturity, and conversion premium categorized by bond rating category. We categorize by bond rating since it is often used as a proxy to measure a company's risk of financial distress (Feinberg et al., 2004). To measure bond rating we use the average of the bond ratings assigned by the three leading rating agencies, Standard & Poors, Moody's, and Fitch. Of our total sample of 790 convertible bonds, 554 are rated. We find that 377 or 68% can be categorized as having a speculative rating, defined in Standard & Poors terminology as having a rating below BBB-, and 177 or 32.0% as investment grade. This split is similar to that found by Davidson et al. (1995) and Lewis et al. (1998), and is consistent with conclusions of Brennan and Schwartz (1988) who argue that convertible debt issues are most likely issued by companies perceived to be of higher risk and higher growth. Therefore, bond rating may be an important factor considered by market participants at the announcement of a convertible debt issue. For example, Mikkelson and Partch (1986) and Jen et al. (1997) find an inverse relationship between the market's response to the announcement of a convertible debt issue and the firm's bond rating. Their findings suggest that high risk issues are viewed more positively by market participants, perhaps due to this belief of corresponding growth opportunities. As expected YTM increases with bond rating, such that, investors are compensated for taking greater risks. Time-to-maturity appears somewhat uniform across bond rating categories, confirming that the rising YTM is due primarily to bond rating and not maturity. There does not appear to be a discernable pattern of conversion premiums across these bond rating categories. This suggests either that the conversion premium taken alone does not provide information of a firm's growth opportunities or that potential growth opportunities are not related to bond ratings. 3. Estimating unanticipated growth As described earlier, our measure of unanticipated growth is calculated as the difference between the implied future growth rate and a one-year pre-event growth rate (Alternatively, we substitute analysts' forecasts of long-term growth for the one-year pre-event
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Table 2 Descriptive statistics for convertible debt issues. Conversion premium Rating category
No.
YTM
Maturity
Mean
Median
AAA to AA− A+ to A− BBB+ to BBB− BB+ to BB− B+ to B− CCC+ to D Non-rated Total
14 46 117 110 209 58 236 790
5.78 5.29 5.81 6.27 6.67 7.08 6.33 6.32
15.66 16.62 17.02 15.13 14.90 17.59 13.43 15.12
19.40 23.99 25.53 22.86 23.16 24.03 25.18 24.12
21.00 22.16 23.45 23.26 22.35 23.02 22.95 22.83
Yield-to-maturity (YTM), time-to-maturity, and conversion premium by initial bond rating for 790 convertible debt issues between 1985 and 2003. Yield-to-maturity (YTM) of the convertible bond is reported in percent. Time-to-maturity (Maturity) is reported in years. The conversion premium is measured as the percentage by, which the conversion price is higher than the spot price of the firm's common stock at the offer date.
growth rate to check the robustness of our results. Results of this alternative measure render similar results.). The one-year pre-event growth rate is our proxy for investor's expectations of a company's growth prior to the announcement of the convertible debt issue. The implied future growth rate is estimated based on conversion premium, yield advantage, and the assumed time for the issue to first be at-the-money. Therefore, unanticipated growth represents the change in growth expectations inferred by market participants from convertible bond issue terms. To estimate an implied future growth rate, conversion premium is calculated as the percentage by which the conversion price is higher than the stock price in effect on the offer date of the convertible debt. Unlike prior studies that calculate yield advantage as the spread of a convertible debt issue over the United States Treasury yield (for example, see Davidson et al., 1995), we calculate yield advantage as the difference in yields between a convertible debt issue and a matched set of straight debt issues. Since we choose our matched set of straight bonds based on comparable ratings and times-to-maturity, our method for calculating yield advantage largely removes the effects of these features on yield. Consequently, we believe our measure of yield advantage better focuses on the yield differential that occurs due to the conversion feature (see Fabozzi, 2000). We assume a projected time for an issue to be at-the-money of three years. This is based, in part, on our findings for our sample that the average time for an issue to be at-the-money is approximately three years. However, we alternately project times for a convertible debt issue to be at-the-money of one to ten years and find varying this assumption does not significantly affect our results. Other studies also find the time for convertible debt issues to be at-the-money to range from one to three years. Davidson et al. (1995) find the average time for issues to be at-the-money to be approximately 1.30 years. Lewis et al. (1998) find that the average time to first call is 2.26 years for investment-grade issues and 2.47 years for speculative-grade issue. Bond yield may be affected by such factors as bond rating, time-tomaturity, and offering date (We consider offering date an important factor since different offering dates may be subject to different systematic risks resulting in a biases in yield comparisons (Hoffmeister et al., 1987; Mann et al., 1999).). Therefore, we control for these factors when forming our set of matched firms issuing straight debt. To control for credit risk we match according to one of six categories of bond ratings; AAA to AA−, A+ to A−, BBB+ to BBB−, BB+ to BB−, B+ to B−, and CCC+ to D. Time-to-maturity is matched according to one of six time periods; below 4 years, 4 to 9 years, 9 to 14 years, 14 to 23 years, 23 to 36 years, and over 36 years. For offering date we match by offer month. Using these matching criteria, straight bonds are chosen if (1) the absolute difference of numeric bond ratings is less than three, (2) the time-to-maturity of a straight bond is between 70% and 130% of the time-to-maturity of a matched convertible bond, and (3) the
absolute difference of the offering month between a straight bond and the convertible bond in our sample and is less than one month (The numeric bond ratings are the average numeric bond ratings assigned by the three leading rating agencies, Moody's, S&P, and FITCH. For example, AAA and D are assigned a numeric value of one and twenty-five, respectively.). It is also the case that the yields of new corporate bonds often differ from almost identical, seasoned bonds (Lindvall, 1977; Ederington, 1974). To control for this situation we estimate yield advantage two separate ways. First, we find the spread difference between our sample of convertible bonds with only those straight bonds that are issued in the primary market. In Table 3 we present our estimates of the implied future growth rate and unanticipated growth based on our calculations of yield advantage, conversion premiums, and our assumed time for a convertible debt issue to be at-the-money. Panel A presents estimates of yield advantages, implied future growth rates, and unanticipated growth when we group according to bond rating and Panel B presents estimates when we group according to the time-to-maturity. Similar to our sample of convertible bonds, we find that for straight bonds both the average YTM increases as ratings decline. In the next column the yield advantage demonstrates the value of the conversion option. The relatively higher yield advantages for speculative bonds indicate that higher risk companies have more to gain by offering a conversion option. This suggests that investors believe that the potential for a future rise in stock price is greater for higher risk companies, where the potential stock return may be due to potential growth opportunities or due to a relatively greater probability of declining risk. This finding provides support for the conjecture that convertible debt offers are an useful financing option for high risk, high growth firms (Brennan and Schwartz, 1981).
Table 3 Estimates of unanticipated growth. Panel A: Unanticipated growth (%) according to bond rating Bond rating
n
Average YTM Yield ad of straight vantage bond (%) (%)
AAA to AA− 12 8.14⁎⁎⁎ A+ to A− 44 8.21⁎⁎⁎ BBB+ to B BB− 103 8.68⁎⁎⁎ BB+ to BB− 81 9.73 B+ to B− 127 10.93⁎⁎⁎ CCC+ to D 23 12.59⁎⁎⁎ Total 390 9.79
2.28⁎⁎ 2.94⁎⁎⁎ 2.67⁎⁎⁎ 3.54 4.15⁎⁎⁎ 5.44⁎⁎⁎ 3.51
Implied future growth rate (%) 8.80⁎ 10.57 10.58 11.54 11.67 12.75 11.21
Pre-event Unanticipated growth growth (%) rate (%) 3.5⁎ 29.9 17.6⁎⁎⁎ 30.6 36.3⁎⁎ 36.0 28.4
5.3⁎ −19.4 −7.0⁎⁎ −19.1 −24.6⁎⁎ −23.2 −17.2
Panel B: Unanticipated growth (%) according to time-to-maturity Maturity
n
Average YTM Yield Implied of straight advantage future bond (%) (%) growth rate (%)
Less than 4 2 6.99⁎ 4 to 9 85 8.70⁎⁎⁎ 9 to 14 105 9.74 92 10.08 14 to 23 23 to 36 104 10.55⁎⁎⁎ Greater than 36 2 7.46 Total 390 9.79
3.12 3.37 3.19⁎⁎ 3.89⁎⁎⁎ 3.69 − 0.11⁎⁎⁎ 3.51
10.44 10.76 10.17⁎⁎⁎ 12.20⁎⁎ 11.97⁎⁎ − 0.11⁎⁎⁎ 11.21
Pre-event Unanticipated growth growth (%) rate (%) 64.0 32.3 39.3⁎⁎⁎ 18.1⁎⁎⁎ 22.9 18.3 28.4
− 53.5 −21.5 −29.2⁎⁎⁎ − 5.87⁎⁎ − 11.0 − 18.4 − 17.2
Yield advantage is the difference between the yield-to-maturity (YTM) of a convertible bond and the average YTM of its matching straight bonds. The implied future growth rate is calculated as a function of the yield advantage and the conversion premium. The pre-event growth rate is measured for the one-year period prior to the convertible debt offering as follows: pre-event growth rate = (St − 371–St − 6)/St − 6 where S is the stock price that is obtained in CRSP database and t0 is the offering date. Unanticipated growth is defined as the difference between the implied growth rate and pre-event stock growth rate. Panel A presents these variables categorized by bond ratings and Panel B presents these variables categorized by time-to-maturity. ⁎⁎⁎, ⁎⁎, ⁎ Indicate significance at the 1%, 5%, and 10% level.
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4. The signaling effect of unanticipated growth
Table 4 Cumulative abnormal returns. Unanticipated growth decile
CAR
t-statistic
Percent negative
Highest 2 3 4 5 6 7 8 9 Lowest Total
− 0.83 − 1.40⁎⁎ − 1.45⁎⁎ − 1.48⁎⁎ − 1.40⁎⁎ − 0.86 −1.56⁎⁎ −3.02⁎⁎⁎ − 5.64⁎⁎⁎ −3.42⁎⁎⁎ −2.11⁎⁎⁎
− 0.56 −2.06 −2.51 −2.07 − 2.14 − 1.30 −2.40 − 4.58 − 5.10 −7.07 − 7.94
67 62 62 72 67 62 69 72 85 87 70
⁎⁎⁎, ⁎⁎, ⁎ Indicate significance at the 1%, 5%, and 10% level. Cumulative abnormal returns (CAR) for a sample of 390 convertible debt offers, partitioned into deciles based on the calculated measure of unanticipated growth. Unanticipated growth is defined as the difference between the implied growth rate and the pre-event growth rate. CARs are taken over a 3-day event window from day − 2 to day 0 relative to the first public announcement of the convertible debt offer.
Similar to yield advantage, the implied future growth rate is found to be inversely related to bond quality. These findings are not surprising considering previous studies. Jen et al. (1997) find a less negative market reaction with the announcement of convertible debt by firms with high capital spending and high leverage. They jointly conclude that convertible debt issues are most beneficial to firms having high growth and also with those having high costs of financial distress. Assuming that high growth companies are typified as having greater risk, this finding is not surprising. It also appears that firms issuing lower-quality bonds are able to garner greater yield benefits since conversion premiums do not increase in relation with declining quality as do implied growth rates. Note that the mean conversion premiums are relatively stable across bond ratings as reported in Table 2. This consistency in conversion premiums suggests that issuers sacrifice growth to reduce their yield obligations. Our calculations of pre-event growth rates are also shown in Table 3. The pre-event growth rate is calculated as the change in the value of common stock over a 365 day window ending 6 days before the convertible debt issue is first announced [(St − 371–St − 6)/St − 6], where S is the stock price obtained from the CRSP database and t0 is the offering date. We find a mean pre-event growth rate of 28.4%, which is much higher than the average implied future growth rate. This finding is consistent with prior research showing that companies issue convertible debt after periods of excessively high growth (Mikkelson and Partch, 1986; Spiess and Affleck-Graves, 1999; Lewis et al., 1999). Importantly, this pre-event growth rate also highlights a problem with using past growth estimates to proxy for future growth, since these periods of high growth often may not reasonably be assumed to continue. Overall, we find that unanticipated growth averages − 17.2% and varies broadly across the sample. However, unlike the implied growth rate, unanticipated growth does not show any discernable pattern across bond ratings. When grouping by time-to-maturity (Panel B of Table 3), we find that the average YTMs of matching straight bonds increase with maturity, suggesting a normal shaped yield curve over much of our period of study. As expected, yield advantage is also shown to rise with maturity. Although convertible bonds are typically converted prior to maturity, this finding suggests that convertible debt offers with longer times to maturity are also expected to have a corresponding longer time to conversion. It also appears that implied future growth rates are positively related with the time-to-maturity. If the highest growth firms are those of the highest risk, this finding is consistent with managers of high risk, high growth firms wanting to extend the maturity of a convertible debt issue to increase the probability that the firm's growth opportunities will be realized prior to issue maturity.
To investigate if our measure of unanticipated growth contains information that is discernable to investors, we examine the relationship between unanticipated growth and announcement period returns. Table 4 presents announcement period returns separated into deciles based on unanticipated growth. The average announcement effect across this sample of 390 convertible debt offers is significantly negative [CAR = −2.11% (t = − 7.94)]. However, this relationship is not monotonic and appears driven by firms with the lowest unanticipated growth, or in other words, those with the poorest future growth prospects. In general, announcement returns are insignificantly different from zero for the highest growth firms, while significantly negative for the lowest growth firms. These results are consistent with Denis' (1994) study of equity issues, where he finds that the announcement period returns are more negative for those firms subject to lower growth. We further investigate the relationship between unanticipated growth and announcement period returns through cross-sectional regression analysis. Several control variables are included to isolate effects attributed to growth from other factors including risk, firm size, and time-to-maturity. As shown in Table 5, we consistently find a significant, positive coefficient for unanticipated growth. Studies that relate most closely to ours include Pilotte (1992), Jung et al. (1996), and Lewis et al. (2003). Pilotte (1992) includes various historic growth proxies, such as, net operating income, sales, and total assets, while
Table 5 Cross-sectional regressions of excess returns around the announcement of a convertible debt issue on issue and issuer characteristics from 1985 to 2003. Three-day cumulative abnormal returns (%) (1)
(2)
−5.401⁎⁎⁎ 0.080 (− 3.71) (0.02) U anticipated 0.018⁎⁎⁎ 0.018⁎⁎⁎ growth (3.17) (3.10) Bond rating − 0.491 −0.919 (− 0.84) (−1.34) Volatility
Intercept
(3)
(4)
(5)
(6)
−1.599 (− 1.12) 0.017⁎⁎⁎
1.673 (0.56) 0.017⁎⁎⁎
−6.051⁎⁎⁎ (− 3.35) 0.016⁎⁎
2.855 (0.72) 0.019⁎⁎⁎
(3.57)
(3.46)
(2.31)
(2.77)
−1.245⁎⁎⁎ −1.273⁎⁎⁎ (− 6.01) (− 6.02)
Leverage Firm size Maturity Finance Utility No obs Adjusted R
2
1.434⁎⁎⁎ (2.81) 0.486 (0.54) −0.459 (−0.60) 359 5.18%
−0.378 (− 1.59) 1.321⁎⁎ (2.55) 0.383 (0.43) 0.224 (0.28) 354 5.07%
1.095⁎⁎ (2.50) − 0.527 (− 0.70) 0.682 (0.97) 356 16.08%
− 0.229 (− 1.31) 1.034⁎⁎ (2.34) − 0.531 (−0.71) 1.262 (1.64) 352 15.32%
−0.896⁎⁎⁎ −1.056⁎⁎⁎ (− 3.80) (− 4.38) − 0.663⁎⁎ (− 2.54) 1.761⁎⁎⁎ 1.778⁎⁎⁎ (2.72) (2.78) − 0.100 0.171 (− 0.09) (0.15) 0.015 0.850 (0.02) (0.90) 245 244 8.95% 11.08%
⁎⁎⁎, ⁎⁎, ⁎ Indicate significance at the 1%, 5%, and 10% level. Shown are ordinary least-square regressions in, which the dependent variable is a three-day cumulative abnormal return and the independent variables are unanticipated growth, bond rating, maturity, finance, utility, volatility. Three-day cumulative market returns (%) are calculated for the three-day horizon around the announcement of convertible debt offerings. Unanticipated growth (%) is defined as the difference between implied annual future stock growth rates and pre-event stock growth rate. Implied annual future stock growth rate is calculated as a function of the yield advantage and the conversion premium. Bond rating is a dummy variable taking a value of one for convertible bonds who se bond rating is BB+ and below. Volatility of the firm's common stock is obtained using the CRSP daily data files for the previous oneyear ending five days prior tot he announcement date. Leverage is defined as the firm's pre-issue debt ratio and is calculated as the book value of debt divided by the sum of the book value of debt plus the market value of equity. Firm size is measured as the log of the market value of equity. Maturity is measured as the natural log of the time to maturity. Finance and Utility are dummy variables rep resenting the group of firms whose business belongs to finance and utility industries. Coefficients t-statistics from the regressions are presented in parentheses.
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analyzing the market reaction for firms issuing common stock, straight debt, and convertible debt. He finds a positive relationship for straight debt issues and that the relationship is not significantly different for convertible debt. However, these findings do not conclusively show a positive relationship between these growth proxies and announcement returns for convertible debt issues. It is possible that the coefficient for the growth variable for convertible debt issues is not significantly different from that for straight debt issue or significantly different from zero, especially considering the small sample size. Using Pilotte's (1992) historic growth proxies; net operating income, sales, and total assets, we find mixed results. Contrary to Pilotte (1992) we find a negative or no relation between these growth proxies and convertible debt announcement returns. This difference could be due to Pilotte (1992) not directly testing this relation for convertible debt issues, an artifact of his small sample, or the difference in time period study. Pilotte's (1992) sample was drawn from the years 1963 through 1984, while ours is from 1985 through 2003. Jung et al. (1996) investigate the relationship between historic growth proxies and announcement returns for a sample of only common stock for the period 1977 to 1984. They find a positive relationship for their growth proxy, the market-to-book ratio. These results differ from Pilotte's (1992) findings that the positive relation between growth and announcement returns does not hold for issues of common stock. As a comparison, for our sample of convertible debt issues we do not find a significant relation between market-to-book and announcement returns. For a sample of convertible debt issues drawn from 1978 to 1992, Lewis et al. (2003) generally do not find a significant relation between their growth proxies, the growth in total assets and market-to-book, and announcement returns. Likewise, when we test the relationship between the growth in total assets and market-to-book with announcement returns we do not find a significant relationship. However, Lewis et al. (2003) do find a negative relation between market-to-book and announcement returns for the subset of convertible debt issues that they classify as being equity-like issues. As such, we also use the design terms of a convertible debt offer, but instead of sorting convertible debt offers into types we use these terms to derive a relative measure of an issuer's growth prospects. Although the purpose of the study by Lewis et al. (2003) and ours differ, the results reinforce the conclusion that the design terms of a convertible debt issue do relate asymmetric information of future growth prospects to investors. To control for factors previously shown to affect announcement returns around convertible debt offers we include other variables in our regression analysis. To investigate the possible effects of risk we use three alternative proxies; bond rating, volatility, and leverage. Bond rating is defined as a dummy variable representing whether a convertible bond is rated investment grade or less than investment grade. Bond ratings is included as a proxy for firm quality, where lowquality firms may be argued to be subject to greater information asymmetry and hence more negative announcement effects Myers and Majluf, 1984; Brennan and Kraus, 1987). In this sense, a company's bond rating is a measure that captures both its business and financial risk. Although we find a negative coefficient for bond rating it is not significant. This finding is consistent with Lewis et al. (1999), who find that credit quality is directly related to announcement effects. Volatility of the firm's common stock is measured by the variation in daily stock returns over a one-year period ending six days prior to the announcement date and is included as an alternative measure of a company's business and financial risk. We find a negative association between announcement returns and volatility. However, these results differ from those of Jung et al. (1996) who find no relationship, and Lewis et al. (1999) who find a positive relationship. We believe our results are more intuitive, since convertible debt issues are issued by firms already somewhat troubled by risk and the increase in risk
brought by the issue my be viewed as increasing costs of financial distress. Leverage is included as a measure of only that portion of a company's risk that can be categorized as financial risk. Leverage is defined as the firm's pre-issue debt ratio and is calculated as the book value of debt divided by the sum of the book value of debt plus the market value of equity. Stein (1992) argues that convertible debt issues offered by highly leveraged firms signal improvements in future performance. This is because managers of these highly leveraged firms issue additional debt only if they are confident that the contractual commitment of the debt can be fulfilled. A contrasting theory is that an increase in financial risk to an already risky firm will greatly increase the expected costs of financial distress. Consistent with this alternative theory, we uncover a negative relationship between announcement effects and leverage. Overall, our findings that risk is negatively correlated with announcement returns are consistent regardless of the proxy used. We hypothesize that to the extent that financial distress and related costs are embodied by our proxies of risk, firms with valuable growth opportunities may be more reluctant to issue debt. However, if growth opportunities are attractive enough, these firms may find that using convertible bonds may be these firms' best option to raise funds. Our results indicate that while market participants react negatively to an issue of convertible bonds by relatively risky firms, they react less negatively for firms with better growth prospects. We argue that these findings support our contention that managers consider the trade-off between risk and growth when setting the terms of a pending issue of convertible debt. These results are also consistent with Brennan and Schwartz's (1981) work demonstrating that convertible debt is used by high-risk, high-growth firms. We include firm size to control for possible differences in information asymmetry across firms. It may be argued that more information is available on larger firms, since these firms are more closely scrutinized by analysts and regulators. Firm size is measured as the log of the market value of equity. We do not find evidence that excess returns are related to firm size. We believe this finding may be an artifact of the fact that our sample is primarily composed of relatively smaller firms. This is consistent with the argument of Brennan and Schwartz (1988) that large firms generally are not presented with a compelling reason to issue convertible debt. We include time-to-maturity as a control measure because it is one of the known features of the issue. Indeed, Lewis et al. (1998) argue that convertible debt issues with longer maturities may be considered more similar to an issue of straight debt than an issue of equity. If this is true, we expect that longer maturity convertible debt offers will have announcement effects similar to those of straight debt. Consistent with the findings of Lewis et al. (1998) we find a significantly positive coefficient for maturity implying that investors react less negatively to the offerings of convertible bonds with longer maturities. As a final control variable we include industry proxies. Since issuers in industries facing greater regulation may face different pricing attributes and growth constraints, we control for possible effects related to firms that are part of the financial services or utility industries. The coefficients for these industry dummies are not found to be significant. We conclude that our results are robust regardless of industry classification. 5. Conclusion In this paper we utilize the terms used in the design of a convertible debt issue to derive a proxy of that firm's future growth prospects. It is our contention that this growth proxy provides a better estimate of any change in the market's perception of growth by addressing the limitation of prior studies. Specifically, we consider the informational content of the terms of a convertible debt issue that
M. Jung, M.J. Sullivan / Journal of Business Research 62 (2009) 1358–1363
existing studies ignore. In contrast, many previous studies of convertible debt issues use historic data to develop proxies of future growth, such as, the year-to-year change in income or assets and the market-to-book value (Pilotte, 1992; Lewis et al., 2003). We believe our technique is more consistent with how market participants interpret the informational content in issue announcements. The proxy of future growth prospects we derive provides the following insights. First, we find that our measure of future growth is often much lower than growth estimated by pre-event period returns. This supports findings of prior studies that companies issue convertible debt after periods of excessively high growth (Mikkelson and Partch, 1986; Spiess and Affleck-Graves, 1999; Lewis et al., 1999; Marciukaityte and Varma, 2007). Consistent with this belief, we find that the change in growth prospects implied by the issue's terms does signal important information to investors. These results are robust after controlling for firm risk, time-to-maturity, firm leverage, and industry effects. In general, our results confirm a relationship between announcement period returns and growth (Jen et al., 1997; Lewis et al., 1999, 2003). Our findings also substantiate the supposition of Brennan and Schwartz (1981) by showing that the use of convertible debt to raise funds is especially useful for high risk, high growth firms. We also argue that the growth proxy developed in this paper may provide greater insight than those growth proxies derived from historic, firm-specific accounting and financial data, such as, the year-to-year change in income or assets and the market-to-book value (Pilotte, 1992; Jung et al., 1996; Munro, 1996; Lewis et al., 2003). The inherent assumption made when using historic data is either that past trends in growth accurately reflect future trends (the use of ex-post measures, such as, growth in income or assets) or that the market has correctly interpreted a firm's future growth prospects (the use of ex-ante measures, such as, market-to-book value). It is important to note that in either case these historic proxies are based on data known prior to the announcement of the convertible debt issue, whereas our model incorporates information included in the issuance announcement. In conclusion, we believe the measure of growth developed in this paper demonstrate that investors react differentially to an announced issue of convertible debt. As such, we suggest an alternative to Denis (1994) who concludes that the relationship between announcement effects and growth is weaker than expected because any effect is significant only when growth opportunities are extremely high. Instead, our model points to the importance of measuring growth opportunities through features of the security design. Our findings support our contention that managers arrange the terms of convertible debt issue to take advantage of their asymmetric information of future growth prospects while considering the trade-off between risk and growth.
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References Brennan M, Schwartz E. The case of convertibles. Chase Financ Q 1981;1:55–64. Brennan M, Kraus A. Efficient financing under asymmetric information. J Finance 1987;42:1225–43. Brennan M, Schwartz E. The case for convertibles. J Appl Corp Finance 1988:55–64. Brown SJ, Warner JB. Using daily stock returns: the case of event studies. J Financ Econ 1985;14:3-31. Dann L, Mikkelson W. Convertible debt issuance, capital structure change and financing-related information. J Financ Econ 1984;13:157–86. Datta S, Iskandar-Datta ME. New evidence on the valuation effects of convertible bond calls. J Financ Quant Anal 1996;31:295–307. Davidson III W, Glascock J, Schwarz T. Signaling with convertible debt. J Financ Quant Anal 1995;30:425–40. Denis D. Investment opportunities and the market reaction to equity offerings. J Financ Quant Anal 1994;29:159–77. Eckbo BE. Valuation effects of corporate debt offerings. J Financ Econ 1986;15:119–51. Ederington LH. The yield spread on new issues of corporate bonds. J Financ 1974;29:1531–43. Fabozzi F. Bond market, analysis and strategies. Fourth edition. Prentice Hall; 2000. Feinberg M, Shelor R, Jiang J. The effect of solicitation and independence on corporate bond ratings. J Bus Finance Account 2004;31:1327–53. Green RC. Investment incentives, debt, and warrants. J Financ Econ 1984;15:115–36. Hansen R, Crutchley C. Corporate earnings and financings: an empirical analysis. J Bus 1990;63:347–71. Hoffmeister JR, Hays PA, Kelley GD. Conditions affecting the timing of convertible bond sales. J Bus Res 1987;15:101–6. Jen FC, Choi D, Lee S. Some new evidence on why companies use convertible bonds. J Appl Corp Finance 1997;10:44–53. Jung K, Kim YC, Stulz RM. Timing, investment opportunities, managerial discretion, and the security issue decision. J Financ Econ 1996;42:159–85. Kim YO. Informative conversion ratios: a signaling approach. J Financ Quant Anal 1990;25:229–43. Lewis CM, Rogalski RJ, Seward JK. Agency problems, information asymmetries, and convertible debt security design. J Financ Intermed 1998;7:32–59. Lewis CM, Rogalski RJ, Seward JK. Is convertible debt a substitute for straight debt or for common equity? Financ Manage 1999;28:5-27. Lewis CM, Rogalski RJ, Seward JK. Industry conditions, growth opportunities and market reactions to convertible debt financing decisions. J Bank Financ 2003;27:153–81. Lindvall JR. New issue corporate bonds, seasoned market efficiency and yield spreads. J Financ 1977;32:1057–67. Mann SV, Moore WT, Ramanlal P. Timing of convertible debt issues. J Bus Res 1999;45:101–5. Marciukaityte D, Varma R. Institutional investors as suppliers of equity-linked capital: evidence from privately placed convertible debt. J Bus Res 2007;60:357–64. Mayers D. Why firms issue convertible bonds: the matching of financial and real investment options? J Financ Econ 1998;47:83-102. Mikkelson WH, Partch MM. Valuation effects of security offerings and the issuance process. J Financ Econ 1986;15:31–60. Munro JW. Convertible debt financing: an empirical analysis. J Bus Finance Account 1996;23:319–34. Myers S, Majluf N. Corporate financing and investment decisions when firms have information that investors do not have. J Financ Econ 1984;13:187–221. Pilotte E. Growth opportunities and the stock price response to new financing. J Bus 1992;65(3):371–94. Spiess KD, Affleck-Graves J. The long-run performance of stock returns following debt offerings. J Financ Econ 1999;54:45–73. Stein JC. Convertible bonds as backdoor equity financing. J Financ Econ 1992;32:3-21.
Contents lists available at ScienceDirect
Journal of Business Research
The signaling effects associated with convertible debt design Mookwon Jung a, Michael J. Sullivan b,⁎ a b
School of Business Administration, Kookmin University, Seoul, Republic of Korea College of Business, University of Nevada Las Vegas, Las Vegas, NV 89154-6008, United States
a r t i c l e
i n f o
Article history: Received 15 February 2008 Accepted 5 November 2008 Jel classifications: G14 G32
a b s t r a c t In this paper we investigate whether the terms used in the design of a convertible debt issue act as a signal of the issuing firm's future growth prospects. Our general premise is that convertible debt design terms are interrelated and arranged in a manner that signals asymmetric information to market participants. Empirical tests support our hypothesis, even after controlling for risk, firm size, time-to-maturity, and industry effects. Firms issuing convertible debt that arrange terms to take advantage of relatively better future growth prospects are found to have a relatively lower negative price reaction around the announcement of the offer. © 2008 Elsevier Inc. All rights reserved.
Keywords: Market efficiency Convertible debt Asymmetric information Signaling
Managers raise funds through issues of debt, equity, and through hybrid securities, such as, convertible debt. As such, managers of some firms find that issuing convertible debt is a more efficient means of raising funds (Green, 1984; Hoffmeister et al., 1987; Stein, 1992; Mayers, 1998). Brennan and Schwartz (1981), Kim (1990), and Mann et al. (1999) demonstrate that due to the risk-neutralizing effect of convertible debt and its role in reducing the underinvestment problem, convertible debt is an especially useful financing tool for high-risk, high-growth firms. Empirically, it has been shown that investors react negatively to the announcement of an issue of convertible debt, but that this market reaction may vary based on an accompanying signal of asymmetric information (Dann and Mikkelson, 1984; Myers and Majluf, 1984; Eckbo, 1986; Mikkelson and Partch, 1986; Hansen and Crutchley, 1990; Marciukaityte and Varma, 2007). Lewis et al. (2003) and Davidson et al. (1995) demonstrate that announcement period returns depend on the design of a convertible debt issue and argue that convertible debt issues that are more ‘equity-like’ suffer greater negative announcement market reactions. Our paper is based on this argument that design features of a convertible debt issue signal information about the issuing firm, specifically regarding future growth prospects. Davidson et al. (1995)
⁎ Corresponding author. Tel.: +1 702 895 4669. E-mail addresses: [email protected] (M. Jung), [email protected] (M.J. Sullivan). 0148-2963/$ – see front matter © 2008 Elsevier Inc. All rights reserved. doi:10.1016/j.jbusres.2008.11.002
create a model to estimate the expected time for a convertible bond to be at-the-money that is based on the conversion price and a priori growth expectations. In a similar manner, we derive a proxy of growth prospects that is based on the design terms of an announced convertible debt issue. Therefore, whereas Davidson et al. (1995) assume a growth rate to estimate the time for a convertible bond to be at-the-money, we make an assumption of at-the-money time to estimate growth. We argue that the pertinent signal provided the market through the terms of an announced convertible issue pertains to growth, which our model estimates directly. Therefore, if managers arrange terms of a convertible debt issue predicated on their asymmetric information of a firm's future growth prospects, and investors can discern this information, this information will be reflected in the stock price reaction at the offer announcement. Our findings offer support for this argument. Higher growth firms are found to have significantly less negative announcement returns than relatively lower growth firms. In addition, we find our growth estimate is robust across various assumed times for the issue to be at-the-money. A robustness check using analysts' long-term growth forecasts to proxy for future growth also supports our findings. The rest of this paper is organized as follows. We describe our growth proxy measure and primary hypothesis in Section 1. Section 2 describes the sample selection and provides descriptive statistics. Section 3 describes how we calculate our growth proxy, which we refer to as unanticipated growth. Section 4 demonstrates the signaling role of this unanticipated growth through an investigation of its relationship to the market reaction around the convertible debt issue announcement. Our conclusions are presented in Section 5.
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1. Growth proxy
Table 1 Summary Statistics for 790 Convertible Debt Issues from 1985-2003.
Convertible debt design involves various terms, such as, issue size, maturity, coupon rate, call features, conversion premium, and the conversion ratio. If there is an interrelationship between convertible debt offer terms and these terms are set considering the firm's future growth prospects, asymmetric information regarding these future growth prospects may be signaled to the market. Therefore, drawing from the work of Green (1984), Kim (1990), Stein (1992), Davidson et al. (1995), Munro (1996), Mayers (1998), and Lewis et al. (1998, 1999, 2003), we utilize design terms of convertible debt issues to derive a measure of implied growth. Specifically, our implied growth measure incorporates yield advantage, conversion premium, and an assumed time for a convertible debt issue to be atthe-money. The question we aim to answer using this growth proxy is whether convertible debt design signals asymmetric information regarding a firm's future growth prospects. Similar to Lewis et al. (1998, 2003) we also use the design terms of a convertible debt offer, but instead of sorting convertible debt offers into types, we use these terms to derive a proxy of an issuer's growth prospects. Our proxy for growth incorporates yield advantage, conversion premium, and an assumed time for the issue to be atthe-money. We define yield advantage as the difference between a firm's convertible debt yield and the yield of a comparable issue of straight debt, and conversion premium as the percentage by which the conversion price is higher than the stock price at the convertible debt offer date. Both yield advantage and conversion premium depend directly on growth prospects. Therefore, if we set the time for a convertible bond to be at-the-money, an estimated growth rate can be estimated and interpreted as the adjusted conversion premium where the adjustment is by yield advantage. We then estimate the change in growth prospects, which we refer to as unanticipated growth, by taking our measure of the implied future growth relative to a benchmark historic growth rate. This brings us to our primary hypothesis, that investors will reassess a firm's growth prospects based on information gleaned from design terms of a convertible bond offer. Therefore, we hypothesize that firms perceived to have higher (lower) growth prospects will be subject to a better (worse) price reaction at the announcement of the convertible debt issue.
Description
Mean
Median
Obs
Issue size ($ Mil) Relative issue value Relative issue amount Conversion premium Call protection Bond maturity (years) Debt ratio before offering Debt ratio after offering Three-day cumulative abnormal return (%)
182.54 0.43 0.22 24.12 3.16 15.12 0.22 0.36 −2.49
100.00 0.24 0.12 22.83 3.00 14.98 0.17 0.33 −1.97
790 527 527 790 718 790 520 520 770
2. Sample selection and descriptive statistics Data for our sample of convertible debt issues and a matched set of straight debt issues are obtained from the Thomson Financial Securities Database and the Fixed Income Securities Database provided by LJS Global Information Services Incorporated (The Fixed Income Securities Database data was obtained through the Fixed Income Research Program at the University of Houston, Bauer College of Business). We confirm all announcement dates using the Wall Street Journal. From the analysis we exclude American depositary receipts, foreign companies, asset-backed securities, warrants, firms without the necessary information on the CRSP Datatapes, and issues where information on conversion premium and yield-to-maturity are not available. The remaining sample includes 790 convertible debt issues from the 1985–2003 period. Table 1 provides summary statistics describing our sample. Compared to a sample of convertible debt issues studied by Lewis et al. (1998, 2003) for the period 1978 to 1992, our sample averages a larger issue size and longer maturity. We attribute these differences to the time periods studied. Otherwise, the samples are comparable. Announcement period returns are calculated for the three-day period ending on the announcement date for the convertible debt offerings using the Brown and Warner (1985) methodology (We use a three-day announcement window because of a possible one-day lag between the issue decision and the formal announcement and because the issue announcement may occur after the market close). We find these announcement period
Issue size is stated in millions of dollars. Relative issue value is defined as the issue size divided by the market value of firm's common stock for the fiscal year-end prior to the issue announcement date. Relative issue amount is defined as the number of shares that can be issued upon conversion divided by the number of shares outstanding for the fiscal year-end prior to the issue announcement date. The conversion premium is the conversion price divided by the market price of common stock the day prior to the issue announcement date. Call protection is the number of years before the convertible issue can first be called. Bond maturity is stated in years. Debt ratio before offering is calculated as the book value of debt divided by the sum of the book value of debt plus the market value of common stock, where the debt ratio after offering is measured at the time of offering as if conversion is assumed to occur at that time. The three-day cumulative abnormal return is from day − 2 to 0 relative to the first public announcement and is significantly different from zero at a 1% level (t-statistic= −8.73).
returns average −2.49% (t-statistic = −8.73). This announcement effect is similar in size and scale to that found by Dann and Mikkelson (1984), Mikkelson and Partch (1986), Hansen and Crutchley (1990), Pilotte (1992), Davidson et al. (1995), Datta and Iskandar-Datta (1996), Jen et al. (1997), and Lewis et al. (1998, 1999, 2003). In Table 2 we present distributional characteristics of our sample of convertible debt issues for yield-to-maturity (YTM), time-to-maturity, and conversion premium categorized by bond rating category. We categorize by bond rating since it is often used as a proxy to measure a company's risk of financial distress (Feinberg et al., 2004). To measure bond rating we use the average of the bond ratings assigned by the three leading rating agencies, Standard & Poors, Moody's, and Fitch. Of our total sample of 790 convertible bonds, 554 are rated. We find that 377 or 68% can be categorized as having a speculative rating, defined in Standard & Poors terminology as having a rating below BBB-, and 177 or 32.0% as investment grade. This split is similar to that found by Davidson et al. (1995) and Lewis et al. (1998), and is consistent with conclusions of Brennan and Schwartz (1988) who argue that convertible debt issues are most likely issued by companies perceived to be of higher risk and higher growth. Therefore, bond rating may be an important factor considered by market participants at the announcement of a convertible debt issue. For example, Mikkelson and Partch (1986) and Jen et al. (1997) find an inverse relationship between the market's response to the announcement of a convertible debt issue and the firm's bond rating. Their findings suggest that high risk issues are viewed more positively by market participants, perhaps due to this belief of corresponding growth opportunities. As expected YTM increases with bond rating, such that, investors are compensated for taking greater risks. Time-to-maturity appears somewhat uniform across bond rating categories, confirming that the rising YTM is due primarily to bond rating and not maturity. There does not appear to be a discernable pattern of conversion premiums across these bond rating categories. This suggests either that the conversion premium taken alone does not provide information of a firm's growth opportunities or that potential growth opportunities are not related to bond ratings. 3. Estimating unanticipated growth As described earlier, our measure of unanticipated growth is calculated as the difference between the implied future growth rate and a one-year pre-event growth rate (Alternatively, we substitute analysts' forecasts of long-term growth for the one-year pre-event
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Table 2 Descriptive statistics for convertible debt issues. Conversion premium Rating category
No.
YTM
Maturity
Mean
Median
AAA to AA− A+ to A− BBB+ to BBB− BB+ to BB− B+ to B− CCC+ to D Non-rated Total
14 46 117 110 209 58 236 790
5.78 5.29 5.81 6.27 6.67 7.08 6.33 6.32
15.66 16.62 17.02 15.13 14.90 17.59 13.43 15.12
19.40 23.99 25.53 22.86 23.16 24.03 25.18 24.12
21.00 22.16 23.45 23.26 22.35 23.02 22.95 22.83
Yield-to-maturity (YTM), time-to-maturity, and conversion premium by initial bond rating for 790 convertible debt issues between 1985 and 2003. Yield-to-maturity (YTM) of the convertible bond is reported in percent. Time-to-maturity (Maturity) is reported in years. The conversion premium is measured as the percentage by, which the conversion price is higher than the spot price of the firm's common stock at the offer date.
growth rate to check the robustness of our results. Results of this alternative measure render similar results.). The one-year pre-event growth rate is our proxy for investor's expectations of a company's growth prior to the announcement of the convertible debt issue. The implied future growth rate is estimated based on conversion premium, yield advantage, and the assumed time for the issue to first be at-the-money. Therefore, unanticipated growth represents the change in growth expectations inferred by market participants from convertible bond issue terms. To estimate an implied future growth rate, conversion premium is calculated as the percentage by which the conversion price is higher than the stock price in effect on the offer date of the convertible debt. Unlike prior studies that calculate yield advantage as the spread of a convertible debt issue over the United States Treasury yield (for example, see Davidson et al., 1995), we calculate yield advantage as the difference in yields between a convertible debt issue and a matched set of straight debt issues. Since we choose our matched set of straight bonds based on comparable ratings and times-to-maturity, our method for calculating yield advantage largely removes the effects of these features on yield. Consequently, we believe our measure of yield advantage better focuses on the yield differential that occurs due to the conversion feature (see Fabozzi, 2000). We assume a projected time for an issue to be at-the-money of three years. This is based, in part, on our findings for our sample that the average time for an issue to be at-the-money is approximately three years. However, we alternately project times for a convertible debt issue to be at-the-money of one to ten years and find varying this assumption does not significantly affect our results. Other studies also find the time for convertible debt issues to be at-the-money to range from one to three years. Davidson et al. (1995) find the average time for issues to be at-the-money to be approximately 1.30 years. Lewis et al. (1998) find that the average time to first call is 2.26 years for investment-grade issues and 2.47 years for speculative-grade issue. Bond yield may be affected by such factors as bond rating, time-tomaturity, and offering date (We consider offering date an important factor since different offering dates may be subject to different systematic risks resulting in a biases in yield comparisons (Hoffmeister et al., 1987; Mann et al., 1999).). Therefore, we control for these factors when forming our set of matched firms issuing straight debt. To control for credit risk we match according to one of six categories of bond ratings; AAA to AA−, A+ to A−, BBB+ to BBB−, BB+ to BB−, B+ to B−, and CCC+ to D. Time-to-maturity is matched according to one of six time periods; below 4 years, 4 to 9 years, 9 to 14 years, 14 to 23 years, 23 to 36 years, and over 36 years. For offering date we match by offer month. Using these matching criteria, straight bonds are chosen if (1) the absolute difference of numeric bond ratings is less than three, (2) the time-to-maturity of a straight bond is between 70% and 130% of the time-to-maturity of a matched convertible bond, and (3) the
absolute difference of the offering month between a straight bond and the convertible bond in our sample and is less than one month (The numeric bond ratings are the average numeric bond ratings assigned by the three leading rating agencies, Moody's, S&P, and FITCH. For example, AAA and D are assigned a numeric value of one and twenty-five, respectively.). It is also the case that the yields of new corporate bonds often differ from almost identical, seasoned bonds (Lindvall, 1977; Ederington, 1974). To control for this situation we estimate yield advantage two separate ways. First, we find the spread difference between our sample of convertible bonds with only those straight bonds that are issued in the primary market. In Table 3 we present our estimates of the implied future growth rate and unanticipated growth based on our calculations of yield advantage, conversion premiums, and our assumed time for a convertible debt issue to be at-the-money. Panel A presents estimates of yield advantages, implied future growth rates, and unanticipated growth when we group according to bond rating and Panel B presents estimates when we group according to the time-to-maturity. Similar to our sample of convertible bonds, we find that for straight bonds both the average YTM increases as ratings decline. In the next column the yield advantage demonstrates the value of the conversion option. The relatively higher yield advantages for speculative bonds indicate that higher risk companies have more to gain by offering a conversion option. This suggests that investors believe that the potential for a future rise in stock price is greater for higher risk companies, where the potential stock return may be due to potential growth opportunities or due to a relatively greater probability of declining risk. This finding provides support for the conjecture that convertible debt offers are an useful financing option for high risk, high growth firms (Brennan and Schwartz, 1981).
Table 3 Estimates of unanticipated growth. Panel A: Unanticipated growth (%) according to bond rating Bond rating
n
Average YTM Yield ad of straight vantage bond (%) (%)
AAA to AA− 12 8.14⁎⁎⁎ A+ to A− 44 8.21⁎⁎⁎ BBB+ to B BB− 103 8.68⁎⁎⁎ BB+ to BB− 81 9.73 B+ to B− 127 10.93⁎⁎⁎ CCC+ to D 23 12.59⁎⁎⁎ Total 390 9.79
2.28⁎⁎ 2.94⁎⁎⁎ 2.67⁎⁎⁎ 3.54 4.15⁎⁎⁎ 5.44⁎⁎⁎ 3.51
Implied future growth rate (%) 8.80⁎ 10.57 10.58 11.54 11.67 12.75 11.21
Pre-event Unanticipated growth growth (%) rate (%) 3.5⁎ 29.9 17.6⁎⁎⁎ 30.6 36.3⁎⁎ 36.0 28.4
5.3⁎ −19.4 −7.0⁎⁎ −19.1 −24.6⁎⁎ −23.2 −17.2
Panel B: Unanticipated growth (%) according to time-to-maturity Maturity
n
Average YTM Yield Implied of straight advantage future bond (%) (%) growth rate (%)
Less than 4 2 6.99⁎ 4 to 9 85 8.70⁎⁎⁎ 9 to 14 105 9.74 92 10.08 14 to 23 23 to 36 104 10.55⁎⁎⁎ Greater than 36 2 7.46 Total 390 9.79
3.12 3.37 3.19⁎⁎ 3.89⁎⁎⁎ 3.69 − 0.11⁎⁎⁎ 3.51
10.44 10.76 10.17⁎⁎⁎ 12.20⁎⁎ 11.97⁎⁎ − 0.11⁎⁎⁎ 11.21
Pre-event Unanticipated growth growth (%) rate (%) 64.0 32.3 39.3⁎⁎⁎ 18.1⁎⁎⁎ 22.9 18.3 28.4
− 53.5 −21.5 −29.2⁎⁎⁎ − 5.87⁎⁎ − 11.0 − 18.4 − 17.2
Yield advantage is the difference between the yield-to-maturity (YTM) of a convertible bond and the average YTM of its matching straight bonds. The implied future growth rate is calculated as a function of the yield advantage and the conversion premium. The pre-event growth rate is measured for the one-year period prior to the convertible debt offering as follows: pre-event growth rate = (St − 371–St − 6)/St − 6 where S is the stock price that is obtained in CRSP database and t0 is the offering date. Unanticipated growth is defined as the difference between the implied growth rate and pre-event stock growth rate. Panel A presents these variables categorized by bond ratings and Panel B presents these variables categorized by time-to-maturity. ⁎⁎⁎, ⁎⁎, ⁎ Indicate significance at the 1%, 5%, and 10% level.
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4. The signaling effect of unanticipated growth
Table 4 Cumulative abnormal returns. Unanticipated growth decile
CAR
t-statistic
Percent negative
Highest 2 3 4 5 6 7 8 9 Lowest Total
− 0.83 − 1.40⁎⁎ − 1.45⁎⁎ − 1.48⁎⁎ − 1.40⁎⁎ − 0.86 −1.56⁎⁎ −3.02⁎⁎⁎ − 5.64⁎⁎⁎ −3.42⁎⁎⁎ −2.11⁎⁎⁎
− 0.56 −2.06 −2.51 −2.07 − 2.14 − 1.30 −2.40 − 4.58 − 5.10 −7.07 − 7.94
67 62 62 72 67 62 69 72 85 87 70
⁎⁎⁎, ⁎⁎, ⁎ Indicate significance at the 1%, 5%, and 10% level. Cumulative abnormal returns (CAR) for a sample of 390 convertible debt offers, partitioned into deciles based on the calculated measure of unanticipated growth. Unanticipated growth is defined as the difference between the implied growth rate and the pre-event growth rate. CARs are taken over a 3-day event window from day − 2 to day 0 relative to the first public announcement of the convertible debt offer.
Similar to yield advantage, the implied future growth rate is found to be inversely related to bond quality. These findings are not surprising considering previous studies. Jen et al. (1997) find a less negative market reaction with the announcement of convertible debt by firms with high capital spending and high leverage. They jointly conclude that convertible debt issues are most beneficial to firms having high growth and also with those having high costs of financial distress. Assuming that high growth companies are typified as having greater risk, this finding is not surprising. It also appears that firms issuing lower-quality bonds are able to garner greater yield benefits since conversion premiums do not increase in relation with declining quality as do implied growth rates. Note that the mean conversion premiums are relatively stable across bond ratings as reported in Table 2. This consistency in conversion premiums suggests that issuers sacrifice growth to reduce their yield obligations. Our calculations of pre-event growth rates are also shown in Table 3. The pre-event growth rate is calculated as the change in the value of common stock over a 365 day window ending 6 days before the convertible debt issue is first announced [(St − 371–St − 6)/St − 6], where S is the stock price obtained from the CRSP database and t0 is the offering date. We find a mean pre-event growth rate of 28.4%, which is much higher than the average implied future growth rate. This finding is consistent with prior research showing that companies issue convertible debt after periods of excessively high growth (Mikkelson and Partch, 1986; Spiess and Affleck-Graves, 1999; Lewis et al., 1999). Importantly, this pre-event growth rate also highlights a problem with using past growth estimates to proxy for future growth, since these periods of high growth often may not reasonably be assumed to continue. Overall, we find that unanticipated growth averages − 17.2% and varies broadly across the sample. However, unlike the implied growth rate, unanticipated growth does not show any discernable pattern across bond ratings. When grouping by time-to-maturity (Panel B of Table 3), we find that the average YTMs of matching straight bonds increase with maturity, suggesting a normal shaped yield curve over much of our period of study. As expected, yield advantage is also shown to rise with maturity. Although convertible bonds are typically converted prior to maturity, this finding suggests that convertible debt offers with longer times to maturity are also expected to have a corresponding longer time to conversion. It also appears that implied future growth rates are positively related with the time-to-maturity. If the highest growth firms are those of the highest risk, this finding is consistent with managers of high risk, high growth firms wanting to extend the maturity of a convertible debt issue to increase the probability that the firm's growth opportunities will be realized prior to issue maturity.
To investigate if our measure of unanticipated growth contains information that is discernable to investors, we examine the relationship between unanticipated growth and announcement period returns. Table 4 presents announcement period returns separated into deciles based on unanticipated growth. The average announcement effect across this sample of 390 convertible debt offers is significantly negative [CAR = −2.11% (t = − 7.94)]. However, this relationship is not monotonic and appears driven by firms with the lowest unanticipated growth, or in other words, those with the poorest future growth prospects. In general, announcement returns are insignificantly different from zero for the highest growth firms, while significantly negative for the lowest growth firms. These results are consistent with Denis' (1994) study of equity issues, where he finds that the announcement period returns are more negative for those firms subject to lower growth. We further investigate the relationship between unanticipated growth and announcement period returns through cross-sectional regression analysis. Several control variables are included to isolate effects attributed to growth from other factors including risk, firm size, and time-to-maturity. As shown in Table 5, we consistently find a significant, positive coefficient for unanticipated growth. Studies that relate most closely to ours include Pilotte (1992), Jung et al. (1996), and Lewis et al. (2003). Pilotte (1992) includes various historic growth proxies, such as, net operating income, sales, and total assets, while
Table 5 Cross-sectional regressions of excess returns around the announcement of a convertible debt issue on issue and issuer characteristics from 1985 to 2003. Three-day cumulative abnormal returns (%) (1)
(2)
−5.401⁎⁎⁎ 0.080 (− 3.71) (0.02) U anticipated 0.018⁎⁎⁎ 0.018⁎⁎⁎ growth (3.17) (3.10) Bond rating − 0.491 −0.919 (− 0.84) (−1.34) Volatility
Intercept
(3)
(4)
(5)
(6)
−1.599 (− 1.12) 0.017⁎⁎⁎
1.673 (0.56) 0.017⁎⁎⁎
−6.051⁎⁎⁎ (− 3.35) 0.016⁎⁎
2.855 (0.72) 0.019⁎⁎⁎
(3.57)
(3.46)
(2.31)
(2.77)
−1.245⁎⁎⁎ −1.273⁎⁎⁎ (− 6.01) (− 6.02)
Leverage Firm size Maturity Finance Utility No obs Adjusted R
2
1.434⁎⁎⁎ (2.81) 0.486 (0.54) −0.459 (−0.60) 359 5.18%
−0.378 (− 1.59) 1.321⁎⁎ (2.55) 0.383 (0.43) 0.224 (0.28) 354 5.07%
1.095⁎⁎ (2.50) − 0.527 (− 0.70) 0.682 (0.97) 356 16.08%
− 0.229 (− 1.31) 1.034⁎⁎ (2.34) − 0.531 (−0.71) 1.262 (1.64) 352 15.32%
−0.896⁎⁎⁎ −1.056⁎⁎⁎ (− 3.80) (− 4.38) − 0.663⁎⁎ (− 2.54) 1.761⁎⁎⁎ 1.778⁎⁎⁎ (2.72) (2.78) − 0.100 0.171 (− 0.09) (0.15) 0.015 0.850 (0.02) (0.90) 245 244 8.95% 11.08%
⁎⁎⁎, ⁎⁎, ⁎ Indicate significance at the 1%, 5%, and 10% level. Shown are ordinary least-square regressions in, which the dependent variable is a three-day cumulative abnormal return and the independent variables are unanticipated growth, bond rating, maturity, finance, utility, volatility. Three-day cumulative market returns (%) are calculated for the three-day horizon around the announcement of convertible debt offerings. Unanticipated growth (%) is defined as the difference between implied annual future stock growth rates and pre-event stock growth rate. Implied annual future stock growth rate is calculated as a function of the yield advantage and the conversion premium. Bond rating is a dummy variable taking a value of one for convertible bonds who se bond rating is BB+ and below. Volatility of the firm's common stock is obtained using the CRSP daily data files for the previous oneyear ending five days prior tot he announcement date. Leverage is defined as the firm's pre-issue debt ratio and is calculated as the book value of debt divided by the sum of the book value of debt plus the market value of equity. Firm size is measured as the log of the market value of equity. Maturity is measured as the natural log of the time to maturity. Finance and Utility are dummy variables rep resenting the group of firms whose business belongs to finance and utility industries. Coefficients t-statistics from the regressions are presented in parentheses.
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analyzing the market reaction for firms issuing common stock, straight debt, and convertible debt. He finds a positive relationship for straight debt issues and that the relationship is not significantly different for convertible debt. However, these findings do not conclusively show a positive relationship between these growth proxies and announcement returns for convertible debt issues. It is possible that the coefficient for the growth variable for convertible debt issues is not significantly different from that for straight debt issue or significantly different from zero, especially considering the small sample size. Using Pilotte's (1992) historic growth proxies; net operating income, sales, and total assets, we find mixed results. Contrary to Pilotte (1992) we find a negative or no relation between these growth proxies and convertible debt announcement returns. This difference could be due to Pilotte (1992) not directly testing this relation for convertible debt issues, an artifact of his small sample, or the difference in time period study. Pilotte's (1992) sample was drawn from the years 1963 through 1984, while ours is from 1985 through 2003. Jung et al. (1996) investigate the relationship between historic growth proxies and announcement returns for a sample of only common stock for the period 1977 to 1984. They find a positive relationship for their growth proxy, the market-to-book ratio. These results differ from Pilotte's (1992) findings that the positive relation between growth and announcement returns does not hold for issues of common stock. As a comparison, for our sample of convertible debt issues we do not find a significant relation between market-to-book and announcement returns. For a sample of convertible debt issues drawn from 1978 to 1992, Lewis et al. (2003) generally do not find a significant relation between their growth proxies, the growth in total assets and market-to-book, and announcement returns. Likewise, when we test the relationship between the growth in total assets and market-to-book with announcement returns we do not find a significant relationship. However, Lewis et al. (2003) do find a negative relation between market-to-book and announcement returns for the subset of convertible debt issues that they classify as being equity-like issues. As such, we also use the design terms of a convertible debt offer, but instead of sorting convertible debt offers into types we use these terms to derive a relative measure of an issuer's growth prospects. Although the purpose of the study by Lewis et al. (2003) and ours differ, the results reinforce the conclusion that the design terms of a convertible debt issue do relate asymmetric information of future growth prospects to investors. To control for factors previously shown to affect announcement returns around convertible debt offers we include other variables in our regression analysis. To investigate the possible effects of risk we use three alternative proxies; bond rating, volatility, and leverage. Bond rating is defined as a dummy variable representing whether a convertible bond is rated investment grade or less than investment grade. Bond ratings is included as a proxy for firm quality, where lowquality firms may be argued to be subject to greater information asymmetry and hence more negative announcement effects Myers and Majluf, 1984; Brennan and Kraus, 1987). In this sense, a company's bond rating is a measure that captures both its business and financial risk. Although we find a negative coefficient for bond rating it is not significant. This finding is consistent with Lewis et al. (1999), who find that credit quality is directly related to announcement effects. Volatility of the firm's common stock is measured by the variation in daily stock returns over a one-year period ending six days prior to the announcement date and is included as an alternative measure of a company's business and financial risk. We find a negative association between announcement returns and volatility. However, these results differ from those of Jung et al. (1996) who find no relationship, and Lewis et al. (1999) who find a positive relationship. We believe our results are more intuitive, since convertible debt issues are issued by firms already somewhat troubled by risk and the increase in risk
brought by the issue my be viewed as increasing costs of financial distress. Leverage is included as a measure of only that portion of a company's risk that can be categorized as financial risk. Leverage is defined as the firm's pre-issue debt ratio and is calculated as the book value of debt divided by the sum of the book value of debt plus the market value of equity. Stein (1992) argues that convertible debt issues offered by highly leveraged firms signal improvements in future performance. This is because managers of these highly leveraged firms issue additional debt only if they are confident that the contractual commitment of the debt can be fulfilled. A contrasting theory is that an increase in financial risk to an already risky firm will greatly increase the expected costs of financial distress. Consistent with this alternative theory, we uncover a negative relationship between announcement effects and leverage. Overall, our findings that risk is negatively correlated with announcement returns are consistent regardless of the proxy used. We hypothesize that to the extent that financial distress and related costs are embodied by our proxies of risk, firms with valuable growth opportunities may be more reluctant to issue debt. However, if growth opportunities are attractive enough, these firms may find that using convertible bonds may be these firms' best option to raise funds. Our results indicate that while market participants react negatively to an issue of convertible bonds by relatively risky firms, they react less negatively for firms with better growth prospects. We argue that these findings support our contention that managers consider the trade-off between risk and growth when setting the terms of a pending issue of convertible debt. These results are also consistent with Brennan and Schwartz's (1981) work demonstrating that convertible debt is used by high-risk, high-growth firms. We include firm size to control for possible differences in information asymmetry across firms. It may be argued that more information is available on larger firms, since these firms are more closely scrutinized by analysts and regulators. Firm size is measured as the log of the market value of equity. We do not find evidence that excess returns are related to firm size. We believe this finding may be an artifact of the fact that our sample is primarily composed of relatively smaller firms. This is consistent with the argument of Brennan and Schwartz (1988) that large firms generally are not presented with a compelling reason to issue convertible debt. We include time-to-maturity as a control measure because it is one of the known features of the issue. Indeed, Lewis et al. (1998) argue that convertible debt issues with longer maturities may be considered more similar to an issue of straight debt than an issue of equity. If this is true, we expect that longer maturity convertible debt offers will have announcement effects similar to those of straight debt. Consistent with the findings of Lewis et al. (1998) we find a significantly positive coefficient for maturity implying that investors react less negatively to the offerings of convertible bonds with longer maturities. As a final control variable we include industry proxies. Since issuers in industries facing greater regulation may face different pricing attributes and growth constraints, we control for possible effects related to firms that are part of the financial services or utility industries. The coefficients for these industry dummies are not found to be significant. We conclude that our results are robust regardless of industry classification. 5. Conclusion In this paper we utilize the terms used in the design of a convertible debt issue to derive a proxy of that firm's future growth prospects. It is our contention that this growth proxy provides a better estimate of any change in the market's perception of growth by addressing the limitation of prior studies. Specifically, we consider the informational content of the terms of a convertible debt issue that
M. Jung, M.J. Sullivan / Journal of Business Research 62 (2009) 1358–1363
existing studies ignore. In contrast, many previous studies of convertible debt issues use historic data to develop proxies of future growth, such as, the year-to-year change in income or assets and the market-to-book value (Pilotte, 1992; Lewis et al., 2003). We believe our technique is more consistent with how market participants interpret the informational content in issue announcements. The proxy of future growth prospects we derive provides the following insights. First, we find that our measure of future growth is often much lower than growth estimated by pre-event period returns. This supports findings of prior studies that companies issue convertible debt after periods of excessively high growth (Mikkelson and Partch, 1986; Spiess and Affleck-Graves, 1999; Lewis et al., 1999; Marciukaityte and Varma, 2007). Consistent with this belief, we find that the change in growth prospects implied by the issue's terms does signal important information to investors. These results are robust after controlling for firm risk, time-to-maturity, firm leverage, and industry effects. In general, our results confirm a relationship between announcement period returns and growth (Jen et al., 1997; Lewis et al., 1999, 2003). Our findings also substantiate the supposition of Brennan and Schwartz (1981) by showing that the use of convertible debt to raise funds is especially useful for high risk, high growth firms. We also argue that the growth proxy developed in this paper may provide greater insight than those growth proxies derived from historic, firm-specific accounting and financial data, such as, the year-to-year change in income or assets and the market-to-book value (Pilotte, 1992; Jung et al., 1996; Munro, 1996; Lewis et al., 2003). The inherent assumption made when using historic data is either that past trends in growth accurately reflect future trends (the use of ex-post measures, such as, growth in income or assets) or that the market has correctly interpreted a firm's future growth prospects (the use of ex-ante measures, such as, market-to-book value). It is important to note that in either case these historic proxies are based on data known prior to the announcement of the convertible debt issue, whereas our model incorporates information included in the issuance announcement. In conclusion, we believe the measure of growth developed in this paper demonstrate that investors react differentially to an announced issue of convertible debt. As such, we suggest an alternative to Denis (1994) who concludes that the relationship between announcement effects and growth is weaker than expected because any effect is significant only when growth opportunities are extremely high. Instead, our model points to the importance of measuring growth opportunities through features of the security design. Our findings support our contention that managers arrange the terms of convertible debt issue to take advantage of their asymmetric information of future growth prospects while considering the trade-off between risk and growth.
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