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Calls of Out-of-the-Money Convertible Bonds
Arnold R. Cowan, Nandkumar Nayar and Ajai K. Singh
Vol. 22, No. 4 (Winter, 1993), pp. 106-116
Stable URL: http://www.jstor.org/stable/3665581
Page Count: 11
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We examine calls of convertible bonds in which the effective cash call price exceeds the value of the common stock into which investors can convert the bond. In option pricing terms, the conversion option available to the convertible bondholder is out-of-the-money. Following the announcement of out-of-the-money calls, the common stock prices of the firms calling their convertible bonds increase an average of 1.43%. The increase occurs over the two-day period in which the firm announces the call, and reflects adjustments for the risk of the stock and market-wide price movements. The prices of called convertible bonds in our sample rise an average of 3.15% in the two-day call announcement period, after adjusting for normal price movements and changes in credit market conditions. Further, we find a positive and statistically significant relation between the abnormal bond and stock returns at the announcement of out-of-the-money calls, so the calls, on average, do not transfer wealth between bondholders and stock-holders. Some theoretical models of optimal call policy in the literature are derived under the assumption that managers and outside investors have the same information. The models imply that an out-of-the-money call would bestow a "needless gain" upon the convertible bondholders. The bondholders' gain would come at the expense of the stockholders. Therefore, out-of-the-money calls would have a negative impact on stockholder wealth and a positive impact on bondholder wealth. Positive common stock price reactions are contrary to such predictions. We conclude that suboptimal call policies do not drive out-of-the-money calls. We argue that the positive stock price response to the call announcements can arise from favorable information signalling by the firm's managers. Previous research supports the theory that a firm calls a convertible bond issue after the conversion value equals or exceeds the call price if managers perceive that the firm's future cash flow outlook has deteriorated. Investors infer the managers' motive, and consequently the stock price declines. Thus, if a firm calls its convertible bonds when the conversion value equals or exceeds the call price, the market will pool such a firm with others whose calls signal unfavorable information. Therefore, managers who instead have favorable information will try to distinguish their firm's call from calls that signal poor prospects. Accordingly, they call their convertibles while the conversion option is out-of-the-money (the conversion value is still below the call price). Investors correctly interpret the announcement and bid up the stock price. The empirical evidence supports this explanation. An alternative motive for a firm to call an out-of-the-money convertible bond is to refund it with a convertible issue that has a lower coupon rate. If the refunding is value-increasing but investors did not expect it, the stock price should rise to reflect the transaction. We looked for actual convertible issuances by firms that made out-of-the-money calls. Only two firms out of 26 issued new convertible securities around the call date, and both raised new funds beyond the amount of cash paid in the call. If refunding were the primary motive for out-of-the-money calls, we would expect to see more issuance activity by the calling firms. We conclude that the evidence does not point to refunding as a primary impetus for out-of-the-money calls. Another possible spur to calls of out-of-the-money convertibles is the presence of restrictive covenants in the indentures of the called bond issues. For example, covenants could limit cash dividend payments or capital expenditures. If the restrictions start to constrain managerial flexibility, they may be eliminated by calling the bonds. We examined the restrictive covenants of the called and other debt of the firms in our sample. We find that the calling firms usually have other outstanding debt with more restrictive covenants than the called convertible issue. Thus, the removal of restrictive covenants does not appear to be the dominant motive for the calls. The results imply that financial managers considering a convertible call may need to consider the information effects of their decisions. Stock market participants probably will interpret calls of out-of-the-money convertible bonds as signals of favorable information about corporate cash flows and in-the-money calls as signals of unfavorable information. Managers also should recognize that the number of out-of-the-money calls available to this study was small, so the conclusions should be considered tentative.
Financial Management © 1993 Financial Management Association International