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E-MailBruce D. Grundy is professor of finance at the University of Melbourne and Patrick Verwijmeren is professor of corporate finance at the Erasmus School of Economics and the University of Melbourne. This post is based on their recent article, published in the Journal of Financial Economics.
Many studies consider optimal security design from the viewpoint of the issuer. Our article investigates the importance of the views of suppliers of capital in the design of securities. We do so by examining a market that has witnessed a major shift in the identity of the suppliers of capital, namely, the market for convertible securities. The convertible market is especially interesting as the shift in the supply side is both observable and towards a supplier with particular design preferences, that supplier being the set of convertible arbitrage hedge funds.
The issuer and the hedge fund perspectives can differ substantially on the question of whether or not to include a call provision in the terms of a convertible bond. A call provision allows the issuer to redeem the convertible before its maturity date. Upon calling, the holder of the convertible is forced to choose between the call price and converting the bond into a specified number of shares. Traditional rationales for why firms issue convertibles take the issuer’s perspective and assign substantial importance to call provisions. For example, call provisions are important in the “backdoor equity” rationale for convertible issuance since they allow a firm to force conversion once the share price has risen.
Now consider the preferences of the suppliers of capital. The principal buyers of convertibles today are hedge funds. Hedge funds combine the purchase of a convertible with a short position in the firm’s stock. Convertible arbitrage strategies are easier to implement when a convertible is not callable. The uncertainty introduced by a call provision complicates hedging by making it more difficult to determine the optimal number of shares to short and complicates the detection of arbitrage opportunities due to the additional need to forecast a firm’s call policy when valuing the firm’s convertible bonds. Importantly, an unanticipated call redistributes wealth from the holders of convertibles to stockholders. Such a redistribution is not a hedgeable comovement of the bond and stock. In the event of a call, convertible arbitrage hedge funds lose on both their long position in the convertible and their short position in the issuer’s stock.
Consequently, we focus on the fluctuating popularity of convertible call provisions to examine the interplay of supplier and issuer preferences in the design of securities. We confirm that the large majority of the convertibles in our sample that were issued before the convertible arbitrage era contained call provisions. If hedge fund preferences are an important determinant of the design of convertible securities today, then the inclusion of call provisions in convertible debt should have decreased in recent years. Indeed, the growth of the convertible arbitrage industry after 2000 has been accompanied by a rapid decrease in the popularity of convertible bond call provisions and only a minority of post-2005 issues has been callable.
We document a strong negative relation between the size of the convertible arbitrage industry and the probability that a newly issued convertible is callable. We also examine the impact of the private placement market for convertibles on the likelihood of incorporating a call provision. Privately placing a security allows issuers and buyers to directly negotiate the design of the security and private placements have been particularly popular with convertible arbitrage hedge funds. Consistent with the preferences of hedge funds, privately placed convertibles are significantly less likely to include call provisions than are publicly issued convertibles.
The demand from convertible arbitrage hedge funds for call-protected convertibles is likely to affect the offering discounts associated with these convertible issues. Indeed, we find that the offering discount for call-protected convertibles is negatively related to the size of the convertible arbitrage industry, which suggests that issuers can offer a lower discount when the supply of capital is larger. For callable convertibles, the discounts are not as sensitive to the size of the convertible arbitrage industry.
Our results establish the importance of the supply side of capital for security design. In particular, we are the first to document the magnitude of the diminution in the popularity of convertible call provisions that has accompanied the growth in convertible hedge funds. A further contribution of our study is that the recent diminution in the popularity of call provisions in convertible debt has provided sufficient cross-sectional variation in whether or not a convertible is callable to allow an analysis of the determinants of the issuer’s desire to include a call provision in a new convertible security. This was not possible when call provisions were ubiquitous. We find evidence that in addition to the preferences of convertible arbitrageurs, other significant determinants of whether a convertible is callable are the opportunity that a call provision gives to (i) reduce problems associated with information asymmetries, (ii) facilitate sequential financing, and (iii) reduce hold-up problems. Thus we provide evidence that security design reflects the interplay of capital supplier and security issuer preferences.
The complete article is available for download here.
