CEO inside debt and convertible bonds

Abstract

The question whether convertible bonds are issued to combat the risk-shifting problem is a subject of debate in the literature, primarily because of the unavailability of clear measures regarding managerial risk-shifting incentives. Taking advantage of recently developed inside debt-holding measures for CEOs, we find strong evidence in support of the risk-shifting hypothesis. When a CEO holds a large amount of inside debt, three distinct patterns emerge: (i) the firm exhibits a lower ratio of outstanding convertibles to total debt;(ii) the firm is less likely to issue convertibles than straight debt; and (iii) the firm devises contract terms to decrease the chance of conversion when it issues convertibles. K E Y W O R D Sconvertible bond, inside debt, risk shifting INTRODUCTIONFinancial economists have been challenged with the task of explaining the issuance of convertible bonds because these hybrid securities do not fit perfectly into the classical capital theories on the equity-debt choice. The risk-shifting hypothesis (RSH), first introduced by Jensen and Meckling (1976), is often proposed as a reason that convertibles are issued. The RSH posits that controlling shareholders pursue a level of asset risk that is excessive from debtholders' point of view because the value of an equity claim is analogous to a call option written on asset value. Risk-shifting firms thus experience relatively strict financing constraints in the debt market.The issuance of convertible bonds rather than straight bonds is a financing strategy that firms can use to offer assurance to their debt investors. Jensen and Meckling (1976) argue that by issuing a bond-warrant combined security, shareholders effectively share part of the proceeds of the increased asset risk with the firm's debtholders, in turn curbing shareholders' incentive to pursue risk. Green (1984) presents a theoretical model and formalizes that intuition.However, the RSH has received limited empirical support in the literature despite its theoretical validity. The main challenge confronted by any empirical test of the RSH is the difficulty of finding clear empirical proxies for managerial risk-shifting incentives. Earlier studies use firm characteristics as their empirical proxies for the degree of risk-shifting problems. Seward (1999, 2003) propose that firms with fewer profitable investment opportunities (measured by the market-to-book ratio) and greater idiosyncratic risk have a higher degree of risk-shifting concern. In a similar vein, King and Mauer (2014) relate a firm's set of investment opportunities to the extent of its agency concerns. Although these variables are arguably associated with agency costs, they do not exclusively capture managerial risk-shifting incentives. For instance, substantial investment opportunities and high risk may occur together with high 232

CEO inside debt holdings and trade credit

“…Indeed, consistent with theoretical prediction, extant studies provide evidence that large CIDH are associated with less risky investment and financial policies (Cassell et al ., 2012). Moreover, CIDH are also associated with a lower likelihood of default (Sundaram and Yermack, 2007), lower payouts (Eisdorfer et al ., 2015), lower marginal values of cash holdings (Liu et al ., 2014), lower levels of outstanding convertible debt relative to total debt (Li et al ., 2018), lower levels of tax sheltering (Chi et al ., 2017), higher accruals quality (He, 2015) and less income smoothing (Shu, 2021). Wei and Yermack (2011) document that a firm’s disclosure of CIDH results in a value transfer from its equity holders to its creditors.…”

Abandon Ship: Deferred Compensation and Risk-Taking Incentives in Bad Times

“…Liu, Mauer, and Zhang (2014) illustrate that inside debt helps protect creditors by favoring cash hoarding behavior. Li, Rhee, and Shen (2018) illustrate that firms whose CEOs hold large inside debt holdings tend to issue less convertible debt, which lines up with a risk-mitigating role of inside debt provided that convertibles are used by firms to curb risk-shifting. Srivastav, Armitage, and Hagendorff (2014) focus on the banking sector and document that inside debt limits managerial risk-shifting through a reduction of incentives to divert cash to shareholders.…”

Inside debt and firm risk‐taking: Evidence from the UK pension reform

“…Our study of CEO inside debt in the UK is a direct response to the previous literature, such as Edmans and Liu (2011) and Li et al. (2018), which explicitly calls for extension of the US study to other countries. OECD (2019) shows that over the last decade (2008–18), 17 out of 22 reporting countries witnessed a significant decline of DB pension.…”

“…They argue that the impact of inside debt on risk‐taking is only tested in the US; whether it applies in another country should be further examined. In a recent study, Li, Rhee, and Shen (2018) call for extending researches of CEO inside debt from the US market to the global market. Using hand‐collected UK pension data, our study extends the literature by examining inside debt in a new market.…”