Why Firms Issue Callable Bonds: Hedging Investment Uncertainty
51 Pages Posted: 21 Mar 2007
Date Written: March 12, 2007
The paper models a firm's dynamic decisions: i) whether to issue a callable or non-callable bond; ii) when to call the callable bond; and iii) whether to refund it when it is called. We argue that callable bonds can be used to hedge investment risk, since they can resolve risk shifting problem when firms' investment opportunities are poor. Our empirical findings strongly support this argument. We find that firms facing poorer future investment opportunities are more likely to issue callable bonds. In addition, firms with higher leverage ratio and higher investment risk are more likely to issue callable bonds. Finally, as firms call back their bonds, non-refunding calls are associated with poor performance and low investment activities, and refunding calls are associated with good performance and high investment activities. Firms with mediocre performance and investment activities tend to not call their bonds.
Keywords: G31, G32
JEL Classification: Callable bond, debt agency problem, risky shifting
Suggested Citation: Suggested Citation