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Why Do Firms Really Issue Convertible Bonds? Evidence from the Field

We conduct interviews with financial managers in Australia, Canada, the U.K., and the U.S. to study the question why companies issue convertible bonds. We also use the responses of the executives to check the validity of the practitioners’ motives and four theories of convertible bonds: risk shifting of Green (1984), management-investor differences in opinion of Brennan and Schwartz (1988), backdoor equity of Stein (1992), and sequential financing of Mayers (1998). 
 
results suggest that for the vast majority of the firms, convertible bonds are chosen because of the lower cost of financing (in terms of both interest cost and covenants) compared to straight debt, and convertible bonds are preferred to equity because of managers’ perceived equity undervaluation and share dilution. Managers time the issuance of convertible bonds based on the demand of the investors and the misvaluation of the firms’ debt and equity. The executives’ responses indicate that managers understand the pitfalls of the convertible instrument rather than naively treating it as cheap debt or cheap equity. The evidence lends considerable support to the theory of management-investor differences in opinion about firm’s risk, but yields very little support to the theories of risk shifting, sequential financing, or backdoor equity. 
 
The interviews also reveal many other insights, such as: convertible bond issues are strongly influenced by market demand, especially from hedge funds; the purpose of call spread overlay in combination with convertible debt is related to reducing share dilution arising from equity undervaluation; cash settlement is tied to both share dilution avoidance and earnings smoothing; and warrant-bond loans are not equivalent to convertible bonds. These findings offer fresh directions for future large sample quantitative research on the motives and characteristics of convertible bonds.