The Consequences of Issuing Convertible Bonds: Dilution and/or Financial Restructuring?

Abstract

Historically, most convertible bond (CB) issues have been converted to equity sooner or later. The announcement of a CB issue will bring about a future dilution of the firm's capital, and is often followed by a drop in share price. However, a CB issue by itself creates future value for the shareholders if it enables the firm to make profitable investments. It can also issue a positive signal regarding the restructuring of the firm's financial liabilities and its attempts to optimise its financial structure. These positive effects, if they occur, will develop gradually after the issue, and cannot be identified by a simple short-term event analysis of a CB issue announcement. In this paper, we test the significance of the dilution effect, coupled with a possible value creation effect, using data from the French stock market. We introduce a comparison between dilutive convertibles and non-dilutive exchangeable bonds. By integrating different corrections and by selecting a window of analysis over a longer period after the announcement of the issue, we show that the negative cumulative average abnormal returns generally observed in previous studies become non-significant. This absence of global incidence is indicative of large differences in individual behaviour by issuers of CBs, and leads us to take into account the strategic choices linked to the issue of a CB. Two goals, often described as 'investment financing' or 'financial restructuring', may exist when issuing, and may appear to explain the size of the abnormal returns.

Mandatory Convertible Notes as a Sustainable Corporate Finance Instrument

“…Upper Trigger 125% Upper Conversion Ratio 0.8 The payoff of MCNs is substantially different to the payoff of standard convertibles ( Figure 5) since there is no downside protection for investors, and it is also different to the total return of the common stock. As opposed to a traditional convertible bond, issuing an MCN implies a sure dilution at maturity, and at the announcement, the underlying stock price should react differently from a standard convertible bond, whereas per Gillet and La Bruslerie the stock price reacts often negatively [26]. In 2013 Kallberg et al [19] described a negative announcement effect in the value of the shares, and a positive effect in the credit default swaps of the issuer.…”

Dlaczego przedsiębiorstwa emitują obligacje zamienne? Analiza polskiego rynku długu zamiennego w latach 2009-2017

“…It appears that nearly all the bonds issued as a part of financial rescue plans are converted into equity, more than half of which in the first week after the issuance. It may suggest that companies sell convertible bonds to reduce time and cost of ordinary share issue, so they can be perceived as a source of cheap debt used to restructure liabilities [Gillet, De La Bruslerie, 2010]. To do so, firms redeem higher coupon corporate bonds and bank credits before maturity and replace them with a relatively cheaper hybrid debt that may be soon transformed into equity capital.…”

“…They also provide the motives for convertible issuances that are more close to business practice. On this basis, convertible debt is often used by undervalued companies as an alternative for common equity or by indebted and unprofitable companies as a cheaper substitute for ordinary corporate bonds and bank loans to restructure their liabilities [Gillet, De La Bruslerie, 2010]. Other reasons for hybrid debt issues include obtaining capital to exercise new investment options [Mayers, 1998], raising funds by smaller companies for further development [Brennan, Schwartz, 1988], financing mergers and acquisitions [Noddings et al, 2001], and earning certain tax benefits [Jalan, Barone-Adesi, 1995].…”

Mandatory Convertible Bonds and the Agency Problem

“…According to this model, at lower company value levels, companies funded with MCBs tend to increase the volatility more than in companies funded with equity and straight debt, since the lower leverage ratios allow them higher risk (Figure 8). However, at higher company values, the incentive to increase risk (entering into riskier projects) decreases [11] due to the potential dilution if the company value reaches the conversion level ( Figure 11); at those levels, MCBs behave like standard convertible bonds [28] (Gillet). As highlighted in Figure 7, when the company volatility was introduced in the model, the value of the debt decreased compared with the static model, and the value of MCB and equity increased.…”