Convertible Bond Underpricing: Renegotiable Covenants, Seasoning and Convergence

Abstract:     
We investigate the long-standing puzzle on the underpricings of convertible bonds. We hypothesize that the observed underpricing is induced by the possibility that a convertible bond might renegotiate on some of its covenants, e.g., an imbedded put option, in financial difficulties. Consistent with our hypothesis, we find that the initial underpricing is larger for lower rated bonds. The underpricing worsens if the issuer experiences subsequent financial difficulties. However, conditional on no rating downgrades, our main empirical result shows that convertible bond prices do converge to their theoretical prices within two years. This seasoning period is shorter for higher rated convertible bonds.

Number of Pages in PDF File: 46

Keywords: Convertible bond, credit risk, valuation

JEL Classification: G12, G13, G14

working papers series