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E-MailThis post comes to us from Darwin Choi, Assistant Professor of Finance at Hong Kong University of Science & Technology, Mila Getmansky Sherman, University of Massachusetts at Amherst, Brian Henderson, Assistant Professor of Finance at George Washington University, and Heather Tookes, Associate Professor of Finance at Yale University.
In the paper, Convertible Bond Arbitrageurs as Suppliers of Capital, which is forthcoming in the Review of Financial Studies, we investigate the role of convertible bond arbitrageurs as suppliers of capital. Convertible bonds have been an important source of financing for a wide variety of firms and have been particularly popular among distressed firms with depressed equity prices. While much smaller than the market for straight debt, the convertible bond market has, at times, been comparable in size to the market for new equity issues. The convertible bond market provides a useful laboratory for studying the role of capital supply on issuance. One reason is that suppliers as a group are fairly well defined. Convertible bond arbitrage hedge funds are widely believed to purchase more than 75% of primary issues of convertible debt. By focusing on a market in which convertible bond arbitrage hedge funds account for such a large fraction of primary market activity, we are able to isolate important measures of capital supply (such as hedge fund flows).
In order to examine the role of capital supply in issuance decisions by firms, this paper uses a simultaneous equations methodology and links convertible bond issuance to a potentially important source of supply: convertible bond arbitrageurs. We document a strong link between variables that capture supply of capital (through hedge fund returns and fund flows, as well as past arbitrage activity) and bond issuance.
Our main finding is that convertible bond arbitrageurs’ ability to supply convertible bond capital (i.e., fund flows) is an important driver of issuance. We also find that demand-side variables such as financial constraints and investment demand proxies (i.e., Q and total issuance in non-convertible debt and equity) all impact issuance in ways that are predicted by theory. In extended analysis that uses an event study methodology, we find additional evidence of a significant role for the supply of capital from arbitrageurs. The September-October 2008 ban on short selling resulted in an unfavorable shift in supply conditions and a decline in issuance.
Beyond providing evidence of an important role for capital supply in firms’ capital structure and issuance decisions, our analysis sheds new light on the role of arbitrageurs in markets: beyond their trading to correct mispricing, they are important suppliers of investment capital to firms.
The full paper is available for download here.
