Why are Convertible Bonds Called Late: Is it Notice Period or the Risk of Financial Distress?

Abstract

A long-standing puzzle in finance, first noted by Ingersoll (1977b), is that many firms delay the re-call of convertible bonds until the bonds’ equity values by far exceed their values as straight debt. Butler (2002) argues that the delay is due to a put option which is granted to investors during the notice period (between the announcement of conversion and the actual event). However, we find this feature to be of minor importance and only capable of generating only a short delay (i.e. a matter of a few weeks rather than several months). An earlier, but largely untested, theory attributes the delay to distress costs (Jaffee and Shleifer, 1990); it argues that some firms would find it extremely difficult to pay-out in cash and they therefore delay until the stock price is sufficiently high to ensure riskless conversion into equity. Consistent with this theory we find for a sample of US convertibles that: (i) the average firm delays calling its convertible until there is only a 1% risk-neutral probability of failure; (ii) proxies for distress costs are significantly related to cross-sectional variation in the conversion premium; and (iii) there is only a very small (and transitory) drop in the share price at the time of the re-call announcement.

Keywords: convertible bonds, late calls, financial distress costs

JEL Classification: G30, G32