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Costs of Financial Distress, Delayed Calls of Convertible Bonds, and the Role of Investment Banks

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  • Jaffee, Dwight
  • Shleifer, Andrei

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.
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Suggested Citation

  • Jaffee, Dwight & Shleifer, Andrei, 1990. "Costs of Financial Distress, Delayed Calls of Convertible Bonds, and the Role of Investment Banks," Scholarly Articles 3606238, Harvard University Department of Economics.
  • Handle: RePEc:hrv:faseco:3606238
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    References listed on IDEAS

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    1. Mikkelson, Wayne H., 1981. "Convertible calls and security returns," Journal of Financial Economics, Elsevier, vol. 9(3), pages 237-264, September.
    2. Harris, Milton & Raviv, Artur, 1985. " A Sequential Signalling Model of Convertible Debt Call Policy," Journal of Finance, American Finance Association, vol. 40(5), pages 1263-1281, December.
    3. Warner, Jerold B, 1977. "Bankruptcy Costs: Some Evidence," Journal of Finance, American Finance Association, vol. 32(2), pages 337-347, May.
    4. Brennan, M J & Schwartz, Eduardo S, 1977. "Convertible Bonds: Valuation and Optimal Strategies for Call and Conversion," Journal of Finance, American Finance Association, vol. 32(5), pages 1699-1715, December.
    5. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-1335, November.
    6. Shleifer, Andrei, 1986. " Do Demand Curves for Stocks Slope Down?," Journal of Finance, American Finance Association, vol. 41(3), pages 579-590, July.
    7. Dann, Larry Y. & Mikkelson, Wayne H., 1984. "Convertible debt issuance, capital structure change and financing-related information : Some new evidence," Journal of Financial Economics, Elsevier, vol. 13(2), pages 157-186, June.
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    Cited by:

    1. King, Tao-Hsien Dolly & Mauer, David C., 2014. "Determinants of corporate call policy for convertible bonds," Journal of Corporate Finance, Elsevier, vol. 24(C), pages 112-134.
    2. Bruce D. Grundy & Patrick Verwijmeren, 2012. "Dividend-Protected Convertible Bonds and the Disappearance," Tinbergen Institute Discussion Papers 12-060/2/DSF37, Tinbergen Institute.
    3. Isagawa, Nobuyuki, 2000. "Convertible debt: an effective financial instrument to control managerial opportunism," Review of Financial Economics, Elsevier, vol. 9(1), pages 15-26.
    4. Stein, Jeremy C., 1992. "Convertible bonds as backdoor equity financing," Journal of Financial Economics, Elsevier, vol. 32(1), pages 3-21, August.
    5. Scruggs, John T., 2007. "Estimating the cross-sectional market response to an endogenous event: Naked vs. underwritten calls of convertible bonds," Journal of Empirical Finance, Elsevier, vol. 14(2), pages 220-247, March.
    6. repec:spr:manint:v:57:y:2017:i:2:d:10.1007_s11575-016-0294-7 is not listed on IDEAS
    7. Asquith, Paul, 1948-, 1992. "Convertible debt--a dynamic test of call policy," Working papers 3413-92., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    8. Altintig, Z. Ayca & Butler, Alexander W., 2005. "Are they still called late? The effect of notice period on calls of convertible bonds," Journal of Corporate Finance, Elsevier, vol. 11(1-2), pages 337-350, March.
    9. Phelps, Katherine L & Moore, William T & Roenfeldt, Rodney L, 1991. "Equity Valuation Effects of Warrant-Debt Financing," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 14(2), pages 93-103, Summer.
    10. Kim, Yong O. & Kallberg, Jarl, 1998. "Convertible calls and corporate taxes under asymmetric information," Journal of Banking & Finance, Elsevier, vol. 22(1), pages 19-40, January.
    11. Bajo, Emanuele & Barbi, Massimiliano, 2012. "The role of time value in convertible bond call policy," Journal of Banking & Finance, Elsevier, vol. 36(2), pages 550-563.
    12. Sarkar, Sudipto, 2003. "Early and late calls of convertible bonds: Theory and evidence," Journal of Banking & Finance, Elsevier, vol. 27(7), pages 1349-1374, July.

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