Is Convertible Debt a Substitute for Straight Debt or Common Equity?

Abstract

This paper examines the ability of the risk-shifting hypothesis and the backdoor-equity hypothesis to explain firms' decisions to issue convertible debt. Using a security choice model that incorporates pre-offer issue, issuer, and macroeconomic information, we document significant variation in the market reaction to new convertible debt issues depending on whether investors expect the motivation for issuance to be asset substitution or asymmetric information. Our results suggest that both motives explain the use and design of convertible debt. Some firms issue convertible debt instead of straight debt to mitigate the costs of bondholder/stockholder agency conflicts. Other issuers issue convertible debt instead of common equity to reduce the costs of adverse selection.

JEL Classification: G31, G32