Working Paper: NBER ID: w2558
Authors: Dwight Jaffee; Andrei Shleifer
Abstract: In a frictionless market with perfect information, a shareholder-wealth- maximizing firm should force conversion of its convertible bond issue into stock as soon as the bond comes in-the-money. Firms however appear to systematically delay forced conversion, sometimes for years, beyond this time. We show that the observed delays can be plausibly explained in terms of costs to shareholders of a failed conversion and the ensuing financial distress. Firms delay the forced conversion to avoid the self-fulfilling outcome that bondholders expect the conversion to fail, tender their bonds for cash, and the stock price falls to account for the costs of financial distress, in which case tendering for cash is in fact optimal. Unlike other explanations of delayed forced conversion, we can explain the common use of investment banks to underwrite these transactions, since the banks can eliminate the self-fulfilling bad outcome.
Keywords: Convertible Bonds; Financial Distress; Investment Banks
JEL Codes: G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Expectation of bondholders (G12) | Firm's decision to delay forced conversion (D25) |
| Costs of financial distress (G33) | Firm's decision to delay forced conversion (D25) |
| Bondholders expecting conversion to fail (G32) | Bondholders tender bonds for cash (G12) |
| Bondholders tender bonds for cash (G12) | Decline in stock price (G17) |
| Decline in stock price (G17) | Drop in firm's fundamental value (G32) |
| Investment banks underwriting forced conversions (G24) | Mitigation of costs associated with failed conversion (G33) |
| Well-structured underwriting agreement (G22) | Elimination of distress costs (J32) |
| Investment bank's role (G24) | Ensuring success of the conversion process (Y20) |
| Presence of investment bank (G24) | Elimination of need for delays in forced conversions (C69) |