Analyzing Callable and Convertible Bonds When the Modigliani-Miller Assumptions are Violated

53 Pages Posted: 4 Mar 2005

See all articles by Chris Hennessy

Chris Hennessy

London Business School

Yuri Tserlukevich

Arizona State University (ASU)

Date Written: December 2004


We analyze callable, convertible, and callable-convertible bonds in a dynamic model with restructuring, taxation, and transaction/bankruptcy costs. In this setting, calling when conversion value equals call price is not generally optimal. Late (early) calls are optimal when the conversion ratio is high (low) and the debt coupon is low (high). If volatility is fixed, pure callable bonds with a substantial call premium maximize firm value, committing equity to second-best restructuring policies. Convertibles are dominated in this context, since the backdoor equity component of the bond is tax-inefficient. The model is extended to allow for instantaneous risk shifting. Call provisions shorten effective maturity, but are not sufficient to induce hedging. Convertible bonds induce hedging, and the optimal conversion ratio trades off incentive provision against tax costs. Convertibles dominate pure callable bonds only when costs of risk shifting are sufficiently high. Although they mitigate risk shifting incentives, no convertible bond can induce global hedging, since equity is infinitely risk loving near default. In addition, convertible bonds exacerbate underinvestment incentives, since conversion privileges reduce marginal q.

Keywords: Capital structure, convertible bonds, callable bonds

JEL Classification: G31

Suggested Citation

Hennessy, Christopher and Tserlukevich, Yuri, Analyzing Callable and Convertible Bonds When the Modigliani-Miller Assumptions are Violated (December 2004). EFA 2005 Moscow Meetings Paper, Available at SSRN: or

Christopher Hennessy

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

Yuri Tserlukevich (Contact Author)

Arizona State University (ASU) ( email )

Farmer Building 440G PO Box 872011
Tempe, AZ 85287
United States

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