Convertible Debt and Shareholder Incentives
43 Pages Posted: 10 Oct 2012 Last revised: 19 Nov 2018
Date Written: September 27, 2013
Given equity’s convex payoff function, shareholders can transfer wealth from bondholders by increasing firm risk. We test the existing hypothesis that convertible debt reduces this classical agency problem of risk-shifting. First, we derive a measure of shareholders’ risk incentives induced by convertible debt using a contingent claims framework. We then document that when risk-shifting incentives are high, the propensity to issue convertible (rather than straight) debt increases and the negative stock market reaction following convertible debt issue announcements is amplified. We further highlight that convertible debt is the only type of security that affects business risk durably downwards. Our conclusions support the agency theoretic rationale for convertible debt financing especially for financially distressed firms.
Keywords: Convertible bonds, Risk-shifting, Asset substitution, Agency conflict, Financial distress, Asset volatility, Contingent claims
JEL Classification: G12, G32
Suggested Citation: Suggested Citation