Callable Bonds: A Risk-Reducing Signalling Mechanism

Abstract

JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org. This content downloaded from 128.235.251.160 on Tue ABSTRACTThe theory of financial economics has failed to distinguish advantages of callable bonds from those of short-term debt. This paper shows that either type of borrowing can signal a firm's better prospects but that short-term debt does so at the cost of weakened risk-sharing with capital markets. By issuing either equity or long-term, non-callable debt, a firm with poor investment opportunities will not pool its prospects with those of a better firm. But equity produces superior risk-sharing. Perhaps this explains the almr,ost complete absence of long-term, non-callable bonds from observed corporate capital structures. FINANCIAL THEORY HAS FOUND only moderate success in explaining the routine inclusion of call provisions among the covenants of corporate bonds. In the absence of market imperfections or incompleteness, the incremental compensation promised to bondholders should exactly offset the value of the call provision retained by equityholders. Indifference should obtain.1 Nevertheless, it is hard to accept indifference as an explanation, given the near universality of call provisions in corporate bond contracts.In this paper, we argue that, in the presence of asymmetric information about investment quality, corporate managers can signal their firm's better prospects by issuing bonds that include call provisions. Our major result shows that this signalling mechanism can be more attractive to risk-averse managers than would be the choice of short-term debt (which could also serve to signal). Furthermore, we demonstrate that non-callable corporate debt is a dominated security. That is, both it and equity signal "Bad News," but equity provides risk-sharing. This finding helps to explain the relative absence of long-term, non-callable debt from corporate financial markets.Previous attempts to explain the prevalence of call provisions in corporate bond contracts fall into four categories. Two categories involve pure wealth transfers from bondholders to stockholders. In these constant sum environments, a gain to one group constitutes a loss to the other. In the first category, managers possess private information with regard to future interest rate movements. Issuing callable bonds will capture gains for stockholders when anticipated drops

Capital Structure Theory and REIT Security Offerings

“…We also find that most of the positive reaction to debt announcements occurs in response to short‐term debt announcements. This runs contrary to the predictions of the Robbins and Schatzberg [17] signalling model but is strongly suggestive of the type of signalling found in Flannery [7] and Slovin and Young [20]. A cross‐sectional analysis revealed that the magnitude of the reaction was not influenced by type of REIT (mortgage or equity), time period, or level of net operating income.…”

“…In this section, we test two signalling models. The model of Robbins and Schatzberg (R‐S) [17] suggests that (a) short‐term debt and long‐term callable bonds both dominate long‐term noncallable bonds as a signalling mechanism and (b) risk‐averse managers will prefer long‐term callable bonds over short‐term debt. A test of their model can be undertaken by examining subsets of our debtissuance sample.…”

Callable Bonds Revisited

“…Alternatively, firms with more free cash flows can easily divert their cash flow from investing in traditional/safer projects to riskier opportunities. Barnea, Haugena, and Senbet (1980) and Robbins and Schatzberg (1986) investigate the use of call provisions in resolving information asymmetry problems. In their models, management possesses positive private information that cannot be credibly revealed to outside investors.…”

Underwriting and Calls of Convertible Bonds*

“…We use a stylized model as in Robbins and Schatzberg (1986) that builds on the basic framework from Harris and Raviv (1985). Our model uses a nonzero call price and a call notice period.…”

“…This terminal cash flow can take on one of two values, namely e = H (high value) or f = M (low value). In our stylized model (see Robbins & Schatzberg, 1986), firm value, v, is assumed to evolve according to the process shown in Figure 1. Specifically, we assume that the probability of being on the upper arm (equivalent to getting closer to the "high" state), y, is such that the expected firm value at time t = 0 satisfies E o ( v l F ) > E , ( e I B ) , and that y I 1 .…”