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Why is Convertible Debt Subordinated? An Investment-Based Agency Theory

This paper offers an agency-based explanation for the junior priority status of convertible bonds. Using a simple economic model, I show that when convertible and straight debt have equal priority, shareholders can prefer value-decreasing projects, which results in wealth transfers from bondholders to shareholders; and I prove that this problem is solved when convertible debt is subordinated. Empirical evidence supports the theory. I find that firms with greater potential for investment-based agency conflicts are more likely to issue subordinated convertible debt, and firms with senior convertible debt are more likely to deviate from the optimal investment policy.