What Drives the Issuance of Putable Convertibles: RiskShifting

What Drives the Issuance of Putable

Convertibles: Risk-Shifting, Asymmetric

Information, or Taxes?

Thomas J. Chemmanur and Karen Simonyan∗

This paper presents the first empirical analysis of firms’ rationale for issuing putable convertiblebonds in the literature. We distinguish between three possible rationales for the issuance ofputable convertibles: 1) the risk-shifting hypothesis, 2) the asymmetric information hypothesis,and 3) the tax savings hypothesis. The results of our empirical analysis can be summarizedas follows. First, putable convertible issuers are larger, less risky firms, having larger cashflows, smaller growth opportunities, and lower bankruptcy probabilities as compared to ordinaryconvertible issuers. Second, putable convertible issuers have lower preissue market valuations,more favorable announcement effects, and better postissue operating performance when comparedto ordinary convertible issuers. Third, putable convertible issuers have better postissue long-runstock return performance as compared to ordinary convertible issuers. Finally, putable convertibleissuers typically have greater tax obligations and better credit ratings than ordinary convertibleissuers. Overall, the results of our univariate as well as multivariate analyses provide supportfor the asymmetric information and tax savings hypotheses, but little support for the risk-shiftinghypothesis.

The objective of this paper is to study financial innovation and the rationale for developinginnovative securities.1 We focus on a specific innovative security, putable convertibles, which areconvertible bonds that allow bondholders to “put” or sell the bonds to the issuer at prespecifiedprices on prespecified dates. Starting from small beginnings in the 80s and early 90s, putableconvertibles have become the most successful financial innovation in the convertible bond marketin the last 5 to 10 years.2 Thus, according to the Securities Data Company (SDC) database, whilethe total amount of capital raised by issuing putable convertibles was only $6.1 billion in the 1980s,it grew to $25.6 billion in the 1990s, and skyrocketed to $122 billion in the 2000s (from 2000 to2003). In fact, in the 2000s, more money was raised by issuing putable convertibles than through

For helpful comments and discussions, we thank Debarshi Nandy, Susan Shu, Bob Taggart, Hassan Tehranian, Chris Veld,An Yan, as well as seminar participants at Boston College, Lehigh University, Seton Hall University, Suffolk University,and conference participants at the 2009 Financial Intermediation Research Society Meetings, the 2006 European FinanceAssociation Meetings, the 2006 Financial Management Association Meetings, and the 2005 Southern Finance AssociationMeetings. We also thank Rayna Kumar for excellent research assistance. Special thanks to an anonymous referee and BillChristie (the editor) for several helpful comments. We alone are responsible for any errors or omissions.

∗Thomas J. Chemmanur is a Professor of Finance at the Carroll School of Management at Boston College in Boston, MA.Karen Simonyan is an Assistant Professor of Finance at the Sawyer Business School at Suffolk University in Boston, MA.

1There is significant empirical and theoretical literature regarding the development of financial innovations. See Schroth(2006) for an example of the former and Herrera and Schroth (2000) for an example of the latter.2The other successful financial innovation in the convertibles market over the last two decades is mandatory convertibles.However, the amounts raised through putable convertibles have by far outstripped the amounts raised through mandatoryconvertibles. See Chemmanur, Nandy, and Yan (2003) for a study of mandatory convertibles.

Financial Management • Autumn 2010 • pages 1027 - 1067

1028 Financial Management � Autumn 2010

Figure 1. Total Proceeds of Putable and Ordinary (Nonputable) Convertible Debt

Offerings Conducted in the United States from 1982 to 2003 by Year of Issue

The numbers represent the total proceeds of all the issues of putable and ordinary convertible debt (with theexclusion of poison put convertible debt offerings) identified in SDC/Global New Issues database for thesample period.

ordinary (nonputable) convertibles: only $109 billion was raised by ordinary convertibles, so thatputable convertibles constituted 52.71% of the total amount raised in the convertibles market (seeFigure 1 ).3,4

Putable convertibles fall into two broad categories: 1) zero coupon putable convertibles (about36% of our sample) and 2) those paying a coupon (about 64% of our sample). It is useful toillustrate various features of putable convertibles using two examples of these issues. The firstexample is the issue of $281.26 million worth of zero coupon putable convertibles by MotorolaInc. on September 27, 1993. Each bond (with a face value of $1,000) was issued at $639.23, hada maturity date of September 27, 2013 (20-year maturity), and was convertible to 5.589 sharesof Motorola common stock at any time prior to maturity. In addition, however, the bonds wereputable by investors to the company on September 27, 1998 (i.e., 5 years from the issue date) at$714.90 and also at 5 years and 10 years after that at prices of $799.52 and $894.16, respectively.Consider now a second example illustrating a coupon paying putable convertible issue. On May 1,2001, Adelphia Communications Corporation issued $500 million worth of putable convertiblespaying 3.25% coupon and maturing on May 1, 2021. The bonds were issued at par and were

3In 2004-2005, there were 160 putable convertible issues raising a total of $38.5 billion. In comparison, there were 214ordinary convertible issues raising a total of $24.0 billion in new capital.4While the focus of this study is on US firms issuing putable convertibles in the United States, a number of Europeanfirms have also issued putable convertibles in the Eurobond market. Examples of such firms are the UK firms Lonrho,Consolidated Gold Fields, BET, Next, the Austrian firm Bank Austria, and the Polish firm Elektrim.

Chemmanur & Simonyan � What Drives the Issuance of Putable Convertibles? 1029

convertible to 22.853 shares each of Adelphia common stock at any time prior to maturity. Thebonds were putable to the firm at par (plus accrued and unpaid interest) on the following dates:May 1, 2003 (two years from the issue date), May 1, 2005, May 1, 2007, May 1, 2011, andMay 1, 2016.5 A key feature worth noting about putable convertibles is that unlike ordinaryconvertible holders (who have no recourse but to wait for the stock price to rise above the strikeprice), putable convertible holders can earn a fair return simply by putting the bond back to theissuer. In other words, unless the stock price rises to a significant premium over the conversionprice, investors may be better off exercising the put option rather than waiting to convert toequity.6

Putable convertibles came under intense scrutiny and attack in the financial press in late 2001and 2002, after a number of companies (e.g., Calpine, Inc.; Marriott International, Inc.; StillwellFinancial, Inc.; and Household International, Inc.) were forced to raise additional financing in theequity or debt market to repurchase the putable convertible bonds issued by them (either partiallyor fully) when investors exercised their put option. Many analysts commented that the firms thatissued these securities were wrongly advised by investment banks that these were sources ofunusually cheap financing, without emphasizing the significant probability of the put options inthese convertible bonds being exercised. “These deals are turning out to be much more expensiveand troublesome for companies than expected, as some were advised that the likelihood of a putwas extremely low . . . CFOs of these firms were not expecting these deals to be put back to themin a year” (“The Convert Boomerang,” Investment Dealers’ Digest, March 2002). It was alsoargued that a company’s outstanding putable convertible issue was contributing to a downwardspiral in both its stock price and credit quality.7 Alternatively, many putable convertible issuersdefended the security saying that the cheap financing they obtained made the risk of the put beingexercised well worth taking, and mentioning that they had either the cash on hand to honor apossible put or were able to raise such cash on favorable terms at short notice.

The above debate among practitioners about the desirability of issuing putable convertiblesraises several interesting questions. First, what is the true rationale behind firms issuing putableconvertibles? After all, we know that in a Modigliani-Miller (1958) setting, issuers should beindifferent between issuing putable and ordinary convertibles. Second, is it indeed the case thatputable convertible issues are received particularly negatively by the stock market as comparedto the issues of convertible debt without such a put provision attached? Third, how do firmsissuing putable convertibles compare with those issuing ordinary convertibles in terms of long-run operating and stock return performance subsequent to the issuance of these securities?Unfortunately, there has been no academic literature on putable convertibles thus far to enableus to answer the above questions. The objective of this paper is to answer these and other relatedquestions by developing the first empirical study of putable convertibles.

5Like most other convertible bonds, both bonds were callable as well. The Motorola issue was callable starting five yearsafter the issue, while the Adelphia Communications issue was callable starting four years after the issue.6It is important to distinguish between putable convertibles and “poison put” convertibles, which are convertible bonds thatbecome putable only in the event of certain corporate events such as a change in control of the firm following a takeover.In contrast, the putable convertibles in our sample become putable on prespecified dates according to a prespecified putschedule (though some of them may also have additional put provisions in the event of some specified corporate events).We exclude pure “poison put” convertibles from our sample since the factors driving the issuance of these seem to bequite different from those driving the issuance of putable convertibles. See Nanda and Yun (1996) for a study of poisonput convertibles. While there were a number of issues of poison put convertibles during the late 80s and early 90s, theissues of such poison put convertibles have been reduced to a trickle in recent years.7See “Headed for a Fall,” (Fortune Magazine, November 26, 2001) and “Convertible Bonds” (The Economist, November14, 2002) for similar comments.


Our primary goal is to identify the factors driving the issuance of putable convertibles. Weanalyze three possible rationales that may drive the issuance of putable convertibles: 1) risk-shifting, 2) asymmetric information, and 3) tax savings. We first discuss the underlying theoryand develop testable hypotheses based on each of these rationales for our empirical analysis. Giventhat the primary difference between putable and ordinary convertibles is the put option enablinginvestors to sell the convertible bond back to the issuer according to a prespecified put schedule,the natural research design to accomplish this task is to compare the various characteristics ofputable and ordinary convertible issuers, as well as the stock return and operating performanceof these firms after the issue. Therefore, we adopt such a research design to distinguish betweenthe risk-shifting, asymmetric information, and tax savings hypotheses regarding firms’ issuanceof putable versus ordinary convertibles.8

We now briefly discuss the risk-shifting, asymmetric information, and tax savings rationalesfor the issuance of putable versus ordinary convertibles (we analyze these in detail in Section I).These rationales are suggested by the existing theoretical literature. The “risk-shifting” or “assetsubstitution” hypothesis is based on the argument that in a setting of incomplete contracting andwhere a firm has a significant probability of financial distress, stockholders have an incentive totake on excessively risky projects in an attempt to transfer wealth from bondholders to themselves.Ordinary convertibles have the ability to mitigate these distortions in stockholder incentives byallowing convertible holders to convert to equity when the stock price is high, thus sharing insome of the “upside” generated by the risky investment strategy adopted by the firm. They cannot,however, eliminate such incentives (Green, 1984). Putable convertibles can further reduce suchincentive distortions by allowing putable convertible holders to obtain their money back if theyobserve the firm engaging in suboptimal investment policies. As we argue in Section I, the testableimplication here is that putable convertibles are more likely to be issued by firms that have bettergrowth opportunities, and those that are smaller and riskier with a greater probability of financialdistress overall.

The “asymmetric information” hypothesis postulates that putable convertibles are issued byfirms with favorable private information (currently undervalued in the stock market), who assessa lower probability of their put option being exercised when compared to overvalued firms(whose insiders have less favorable private information about their firm value). Thus, firms withmore favorable private information (undervalued firms) will issue putable convertibles whilethose with less favorable private information will issue ordinary convertibles. As we argue inSection I, this has the testable implication that in addition to being undervalued, firms issuingputable convertibles will have more favorable announcement effects and better postissue operatingperformance as compared to a matched sample of ordinary convertible issuers.

The tax savings hypothesis argues that putable convertible issuers may be partially motivatedby their desire to save on income taxes (see Section I for details). This has the testable predictionthat firms that have greater income tax obligations and those in higher credit rating categories(who will have more income to shelter from taxes) are more likely to issue putable rather thanordinary convertibles.9

8In principle, one can compare the characteristics of putable convertible issuers to those of not only ordinary convertibleissuers, but also issuers of other securities like straight debt and common stock (as well as other innovative securities).However, there may be a number of market imperfections that may affect a firm’s choice of equity versus debt (as well asother securities). Given that there is no consensus in either the theoretical or the empirical literature regarding the specificimperfections driving the above choice, it is impossible to include all of these imperfections in our empirical analysis.Therefore, the approach we have taken here is to compare putable convertibles with the closest “standard” securitiesissued by firms, which are clearly ordinary convertibles.9We also develop testable implications arising from the above three theories for subsamples of putable convertible issuersthat we discuss in Section I.


Our results can be summarized as follows. First, firms that issue putable convertibles arelarger, less risky firms with smaller growth opportunities and a lower overall probability ofbankruptcy as compared to those issuing ordinary convertibles. These results do not supportthe risk-shifting hypothesis. Second, putable convertible issuers have lower preissue marketvaluations when compared to ordinary convertible issuers. Third, they also experience morefavorable abnormal stock returns upon the announcement of an issue as compared to a matchedsample of ordinary convertible issuers. Fourth, putable convertible issuers exhibit better long-runpostissue operating performance when compared to firms issuing ordinary convertibles. Fifth,among putable convertible issuers, the subsample of firms issuing putable convertibles with largerconversion premia (i.e., with conversion options that are more out of the money) have lowerpreissue market valuations, more favorable announcement effects, and better long-run operatingperformance than the subsample of firms issuing putable convertibles with smaller conversionpremia. The last four results broadly support the predictions of the asymmetric informationhypothesis. Sixth, firms issuing putable convertibles have greater income tax obligations thanthose issuing ordinary convertibles. Additionally, a greater proportion of putable convertibleissues fall into higher credit rating categories as compared to ordinary convertible issues. Thesetwo results support the tax savings hypothesis, with the latter result being inconsistent withthe risk-shifting hypothesis. Finally, putable convertible issuers exhibit better long-run stockreturn performance in the years after the issue when compared to ordinary convertible issuers.Overall, our empirical analysis provides support for the asymmetric information and tax savingshypotheses, but relatively little support for the risk-shifting hypothesis.

Our paper is related to three strands in the literature. The first strand is the empirical and the-oretical literature regarding the development of financial innovations. An important contributionto this literature is Tufano (1989), who demonstrates that imitation occurs shortly after the firstissue of a new security and that the development cost is significantly smaller for imitators than forinnovators. Schroth (2006) measures the difference in value to firms from raising money using asecurity engineered by an innovator versus an imitator, and explains part of the innovator’s marketshare advantage. The theoretical literature on innovation has argued that innovators may facelower search costs of identifying issuers and investors (Allen and Gale, 1994) or lower marketingcosts if there are fixed costs of setting up marketing networks (Ross, 1989). In a related paper,Bhattacharyya and Nanda (2000) argue that innovators may be able to appropriate a larger fractionof the value generated by their innovations despite the entry of imitators if switching by clientsto other underwriters is costly.

The second strand in the literature that our paper is related to is the theoretical and empiricalliterature regarding specific financial innovations, especially those involving convertible features.Examples of this literature are Chatterjee and Yan (2008) who study contingent value rights(CVRs) in takeovers, Chemmanur, Nandy, and Yan (2003) who develop a theoretical and empiricalanalysis of mandatory convertibles, Hillion and Vermaelen (2004) who develop a theoretical andempirical analysis of “death spiral” convertibles, and Nanda and Yun (1996) who study “poisonput” convertibles (see Footnote 6 for the distinction between putable and poison put convertibles).While all of the above papers study innovative securities with convertible features, none of thesepapers focus on putable convertibles.

The third strand in the literature related to our paper is the theoretical and empirical litera-ture regarding ordinary convertibles. The theoretical literature concerning ordinary convertiblesincludes Stein (1992), Green (1984), Constantinides and Grundy (1989), Mayers (1998), andBrennan and Kraus (1987). The large empirical literature about ordinary convertibles includes,among others, Dann and Mikkelson (1984), Billingsley and Smith (1996), Spiess and Affleck-Graves (1999), and Lewis, Rogalski, and Seward (1999, 2001). Our paper is also indirectly related


to the theoretical and empirical literature concerning the information content of a firm’s call policyregarding the ordinary convertibles it has issued (Harris and Raviv, 1985; Nyborg, 1995; Brick,Palmon, and Patro, 2007).10

The rest of this paper is organized as follows. Section I discusses theory and develops testablehypotheses. Section II describes our data. Section III presents our empirical tests and resultsconcerning three possible rationales for issuing putable convertibles. Section IV explores analternative explanation suggested by practitioners for the issuance of putable convertibles, whileSection V provides our conclusions.

I. Theory and Hypotheses

A. The Risk-Shifting or Asset Substitution Hypothesis

It is well known that when a firm has a significant probability of financial distress, outstandingdebt can distort the incentives of equity holders in a setting of incomplete contracting aboutthe firm’s investment policy, motivating them to engage in risk-shifting (Jensen and Meckling,1976) or underinvestment (Myers, 1977). Green (1984) demonstrates that ordinary convertibledebt can mitigate the above loss in value due to the risk-shifting incentives of stockholders. Sinceconvertible holders have the ability to convert this debt to equity when equity value is high (so thatequity holders will have to share any increased equity value arising from risk-shifting with theseconvertible debt holders) equity holders’ incentives to engage in risk-shifting in the first placeis reduced when ordinary convertibles are issued rather than straight debt. However, as Green(1984) notes, ordinary convertibles can only mitigate the incentives of equity holders to engagein risk-shifting and the pursuit of other suboptimal investment policies. They cannot eliminatesuch investment distortions. In this situation, putable convertibles can further reduce the abovedistortions in stockholder incentives by allowing putable convertible holders to demand theirmoney back (on the next available put date) if they observe the firm engaging in risk-shifting orother suboptimal investment policies. In contrast, since such a put provision is absent, the onlyrecourse of ordinary convertible debt holders is to wait until the equity value increases to the pointwhere it is optimal for them to convert to equity, thus sharing in any value gains created by thefirm’s investment policies (a recourse also available to putable convertible holders). In summary,putable convertibles are able to control distortions in stockholder incentives more effectively thanordinary convertibles.11

10There is a small theoretical and empirical literature regarding straight putable bonds (see David, 2001, for a theoreticalanalysis of the strategic value of such bonds in liquidity crises and Cook and Easterwood, 1994, for an empirical analysisof straight poison put bonds). Our paper is also indirectly related to the larger literature concerning raising externalfinancing under asymmetric information (Myers and Majluf, 1984).11A formal theoretical development of these arguments can be found in an appendix to the working paper version ofthis article. Thus, consider a firm’s choice between three mutually exclusive projects: 1) a safe project, S, that has thelowest risk (standard deviation of cash flows) but highest NPV; 2) a medium-risk project, M , that has the next highestrisk but lower NPV than Project S; and 3) a high-risk project, R, that has the highest risk but lowest NPV. We firstdemonstrate that, under suitable parameter variables, a firm that issues debt to finance its project will choose Project Rdue to the risk-shifting considerations discussed in Jensen and Meckling (1976). However, if a firm that has all threeprojects available it issues putable convertibles to finance its project, and then the firm chooses the highest NPV (andsafest) Project S. Alternatively, if the same firm issues ordinary convertibles, it continues to choose Project R. If, however,a firm with only two projects, S and M , available to it issues ordinary convertibles, then the firm chooses the highest NPVProject S. This illustrates that when the portfolio of projects available to a firm is not too risky, ordinary convertiblesare sufficient to eliminate the risk-shifting problem; however, if the portfolio of projects is very risky, then only putableconvertibles can accomplish this task. In summary, the equilibrium choice of security issued by a firm depends on the


On the cost side, however, the put option in putable convertibles means that stockholders’ abilityto pursue genuinely value increasing long-term investment strategies may be circumscribed by thefact that convertible holders may put the bonds back to the firm if its stock price were to go down,even due to factors outside the stockholders’ (managers’) control. Thus, under the mitigationof risk-shifting hypothesis, putable convertibles will be issued by those firms whose benefitsfrom controlling distortions in the firm’s investment policies outweigh any costs of issuing thesesecurities.12

The risk-shifting hypothesis leads to the following testable implications. First, since the prob-ability of asset substitution is greater for firms with more growth opportunities (which tend tobe riskier firms), this hypothesis predicts that such firms are more likely to issue putable ratherthan ordinary convertibles (H1). Second, the greater the probability of bankruptcy, the greater theincentives of stockholders to engage in risk-shifting. Thus smaller and riskier firms or those withhigher existing financial leverage (those with a greater probability of financial distress overall)are more likely to issue putable rather than ordinary convertibles under this hypothesis (H2). Forsimilar reasons, the risk-shifting hypothesis predicts that a greater proportion of putable convert-ible issues will be in the lower credit rating categories as compared to ordinary convertible issues(H3A).

Given that the risk-shifting hypothesis does not postulate any ex ante private information onthe part of firm insiders at the time of security issue (and, therefore, no differences in privateinformation across putable and ordinary convertible issuers), the risk-shifting hypothesis predictsno difference in the announcement effects across the two types of security issues (H4A). Forsimilar reasons, the risk-shifting hypothesis also implies that there will be no difference in themarket valuation of firms issuing putable versus ordinary convertibles prior to the issue (H5A).Finally, the risk-shifting hypothesis predicts no difference in the postissue operating performanceof firms issuing putable versus ordinary convertibles (H6A). As we discuss in Footnote 11, therisk-shifting hypothesis implies that firms having a highly risky portfolio of projects available tothem will issue putable convertibles in equilibrium while those having a less risky portfolio willissue ordinary convertibles. Since, in each case, the firm will optimally eliminate the risk-shiftingproblem faced by it, one should expect to find no difference in postissue operating performanceacross the issuers of the two kinds of convertibles.13

portfolio of projects available to it. Firms having a highly risky portfolio of projects will issue putable convertibles, whilethose having a less risky portfolio of projects will issue ordinary convertibles, in each case eliminating the risk-shiftingproblem faced by it.12One can also think of the benefit of raising external financing by issuing putable convertibles in Jensen’s (1986) “freecash flow” framework. Putable convertibles allow investors to reduce managerial discretion in making use of the firm’scash flows (by putting the convertibles back to the firm) contingent upon observing a greater potential for the wastage ofthese cash flows (due to the lack of availability of a sufficient number of positive net present value projects to the firm).If the firm were to issue ordinary convertibles or straight debt instead, the above ability of investors to reduce managerialdiscretion in using the firm’s cash flows would not be contingent on the firm’s investment opportunity set.13One may at first conjecture that the postissue operating performance of firms issuing putable convertibles can beexpected to be better than that of firms issuing ordinary convertibles since while ordinary convertible issuers continue toinvest in suboptimal risky projects, the put feature will provide the putable convertible issuers with incentives to refrainfrom choosing such projects. For such a conjecture to be valid, we need to make the additional assumption that whilefirms issuing putable convertibles are making their equilibrium choice, those issuing ordinary convertibles are actingout of equilibrium when they choose to issue that security (i.e., they could benefit from issuing putable convertiblesinstead). In contrast, in developing Hypothesis H6A, we are assuming that both types of convertible issuers are makingtheir equilibrium (optimal) choice of security. We thank an anonymous referee for suggesting that we address this issue.


B. The Asymmetric Information Hypothesis

Consider a situation where insiders have information superior to outsiders about the futureearnings and cash flows of their firm (and, as such, about the intrinsic value of its equity). In thissituation, insiders of a firm whose equity is currently undervalued relative to its intrinsic valueare more likely to bundle a put option when issuing convertible debt compared to insiders ofa firm that is overvalued. This is because insiders of a firm with favorable private informationabout its future cash flows are aware that once their private information is public, their firm’sequity value will reflect this, so that the put option bundled with its convertible debt issue is lesslikely to be exercised. In contrast, it would be costly for insiders of a firm with less favorableprivate information to mimic the above strategy as their stock price is more likely to fall whentheir private information becomes public, increasing the probability that any put options bundledwith their convertible debt issue will be exercised. This, in turn, implies that rational investorswill infer that any firm issuing a putable convertible is an undervalued (rather than an overvalued)firm.14

The above theory has several implications for issuers’ choice between putable and ordinaryconvertibles. First, the above theory predicts that the announcement effects in the equity market tofirms issuing putable convertibles will be more favorable (less negative) than those of a matchedset of firms issuing ordinary convertibles (H4B). Second, the average market valuation of putableconvertible issuers prior to the issue (as measured by the ratio of price to intrinsic value, whereintrinsic value is calculated conditional on insiders’ private information) will be lower than theaverage market valuation of ordinary convertible issuers (H5B). Third, the postissue operatingperformance of putable convertible issuers will be better than that of ordinary convertible issuerssince the favorable private information of putable convertible issuers regarding their firms’ futurecash flows is realized over time (H6B).15

We now develop the implications of the asymmetric information hypothesis for subsamplesof firms issuing putable convertibles based on conversion premium (i.e., the extent to which thestock price must rise for the conversion option to be in the money).16 In order to develop theseimplications, we consider an extension of the Stein (1992) asymmetric information model ofconvertible debt issuance, where we allow a firm facing asymmetric information in the financialmarket to signal not only through its choice of security issued, but also through the conversionpremium (when the chosen security is a convertible). In Stein’s (1992) model, there are three dates:Times 0, 1, and 2, and three types of firms (good G, medium M , bad B) differing in their abilityof realizing a high rather than a low cash flow at Time 2. This probability is private informationto firm insiders at Time 0. In addition, the lowest type, B, faces a probability of “deterioration.” If

14One way to think of the put option in a convertible issue is as something akin to a “money-back guarantee” or a warrantyin the product market. Clearly, the manufacturers of higher quality products (similar to undervalued firms in our setting)are more likely to offer such money-back guarantees as compared to manufacturers of lower quality products (akin toovervalued firms in our setting) since the former are aware that consumers are less likely to use their guarantee. SeeGrossman (1981) for a formal model as to how warranties can signal quality in the product market and Gibson and Singh(2002) for a theoretical model of how put options attached to equity can signal insiders’ favorable private informationabout their firm’s intrinsic value to outsiders.15A formal theoretical development of these arguments, applied specifically to the issuance of putable versus ordinaryconvertibles, is available in an appendix to the working paper version of this article. We demonstrate there using atheoretical example that under suitable parameter values, higher intrinsic value firms facing a choice between putable andordinary convertibles under asymmetric information will issue putable convertibles in equilibrium, while lower intrinsicvalue firms will issue ordinary convertibles.16We thank an anonymous referee for suggesting that we conduct an analysis of subsamples of firms issuing putableconvertibles based on their conversion premium (i.e., the extent to which their conversion options are out of the money).


the firm deteriorates, it realizes a low cash flow with certainty. The menu of securities availableto firms is straight debt, ordinary convertibles, or equity. Any firm that cannot meet its paymentobligations under either kind of debt (straight or convertible) faces an exogenous cost of financialdistress. While final cash flows are realized only at Time 2, the true type of firms (i.e., the privateinformation of insiders) is publicly revealed at Time 1. This will be reflected in the firm’s stockprice at this date. In equilibrium, type G firms issue straight debt, type M firms issue ordinaryconvertibles, and type B firms issue equity. The intuition here is that type G firms are confidentin realizing a high cash flow; as such, they do not face a significant probability of having to paythe distress cost allowing them to issue debt. Type B firms do not wish to issue either kind of debtsince they assess a significant probability of cash flow deterioration thus being forced to pay thedistress cost if they issue any debt. Therefore, they issue equity. Type M firms issue convertibledebt allowing them to avoid pooling with type B firms and simultaneously avoiding incurring thedistress cost as they are confident their stock price will be high enough by Time 1 that convertibleholders will convert to equity.

We now extend the Stein (1992) model by adding putable convertibles to the menu of securities(replacing straight debt in that model), keeping the other two securities in the menu (ordinaryconvertibles and equity) the same. We also assume four types of firms: 1) G1, 2) G2, 3) M , and4) B each differing in their probability of realizing a high rather than a low cash flow, which isprivate information to firm insiders. Type G1 has a greater probability of realizing a high cashflow than type G2, which, in turn has a higher probability of realizing a high cash flow than typeM . Finally, firm insiders can signal their type (private information) using a combination of twosignals: 1) the choice of security to issue and 2) the conversion premium (if they choose to issue aconvertible, is it putable or ordinary). All other assumptions are as in Stein (1992). In this setting,it can be demonstrated that type G1 firms will issue putable convertibles with a high conversionpremium (i.e., with the conversion option more out of the money), and type G2 firms will alsoissue putable convertibles, but with a low conversion premium. The other two types of firms,M and B, will issue ordinary convertibles and equity, respectively, as in the Stein (1992) model.The intuition behind the above choices is as follows. The two highest types issue putable ratherthan ordinary convertibles since they assess a great enough probability of realizing a high cashflow; as such, they assess only a low probability of the put attached to the convertible being inthe money and, therefore, being exercised at Time 1. Type G1 issues putable convertibles with ahigher conversion premium than type G2 given that insiders expect their firm’s stock price to riseto a higher extent from current levels than that of type G2. As such, they will set the strike priceof the conversion option of the putable convertible at a higher level than that set by type G2 firminsiders. The intuition behind type M issuing an ordinary rather than a putable convertible is asfollows. The insiders of type M firms assess a greater probability than the G1 or G2 type firmsthat if they bundle a put option with their convertible debt, it will be exercised. The intuitionbehind type B firms issuing equity rather than any kind of debt is similar to that in the Stein(1992) model.

Thus, our extension of the Stein (1992) model implies that firm insiders with more favorableprivate information will issue putable convertibles with a high conversion premium. This has threetestable predictions for subsamples of firms issuing putable convertibles. First, the announcementeffects in the equity market of putable convertible issues with a high conversion premium relativeto a matched set of ordinary convertible issues will be more favorable than that of putableconvertible issues with a low conversion premium (H7). Second, the average market valuationof firms issuing putable convertibles with a high conversion premium prior to the issue (asmeasured by the ratio of price to intrinsic value, where intrinsic value is calculated conditionalon insiders’ private information) will be lower than that of firms issuing putable convertibles


with a low conversion premium (H8). Additionally, the postissue operating performance of firmsissuing putable convertibles with a high conversion premium will be better than that of firmsissuing putable convertibles with a low conversion premium (H9) as the more favorable privateinformation of the former category of firms will be realized over time.

The private information hypothesis does not predict any differences in the long-run stock returnperformance of putable and ordinary convertible issuers if outside investors are fully rational andthe stock market is completely efficient. This is because such investors will fully infer the insiders’private information from their decision to issue putable rather than ordinary convertibles. As such,this inference will be fully reflected in the stock price on the day of the announcement. In otherwords, there will be no differences in the long-run returns measured subsequent to the issue. If,however, investors are only boundedly rational, so that the insiders’ private information is not fullyreflected in the stock price on the announcement day, but is incorporated over a longer period, thenone would expect superior long-run performance from putable convertible issuers when comparedto a matched sample of ordinary convertible issuers. In any case, long-run stock returns oftengo hand in hand with operating performance. As such, it is worth comparing the long-run stockreturn performance of putable and ordinary convertible issuers, at least as a robustness check.Therefore, this is the tenth hypothesis (H10) that we test here.17,18

C. The Tax Savings Hypothesis

The tax savings hypothesis argues that putable convertible issuers may be partially motivatedby their desire to save on corporate income taxes. A significant proportion of putable convertiblesare zero-coupon bonds (36% in our sample) and the present value of deductions from taxableincome is greater for such bonds since the “contingent debt” feature of the tax code allows theoriginal issue discount of zero-coupon bonds to be deducted yearly (similar to coupon paymentsin the case of coupon-bearing bonds) even though the issuing firm does not make any cashpayments to investors until the maturity date. However, one disadvantage of zero-coupon putableconvertibles to investors is that no cash flows are paid to them until the maturity date, so that theeffective maturity of the bond is longer (relative to a comparable coupon-bearing bond). Thus,under the tax savings hypothesis, issuers who want to reduce taxes by issuing zero-coupon bondsmay include a put provision in these bonds as a “sweetener” for investors (reducing the effectivematurity back to acceptable levels by allowing investors to obtain their money back earlier if theyso desire).19

This hypothesis has three testable implications. First, it predicts that firms that have greaterincome tax obligations are more likely to issue putable rather ordinary convertibles (H11).

17Of course, if the stock market reflects insiders’ private information only over a longer period of time, the difference inabnormal returns on the announcement day between putable and ordinary convertible debt issuers will be correspondinglyreduced.18Note that all long-run stock return studies around corporate events require the assumption of bounded rationality orlimited market efficiency, similar to the one we make here. One may consider this to be a strong assumption, but given thelarge empirical literature documenting the postevent drift following earnings announcements and many other corporateevents (Foster, Olsen, and Shevlin, 1984; Bernard and Thomas, 1989), one has to at least consider the possibility thatthe information revealed by many corporate actions is not always instantaneously reflected in the stock price. Further,given the sizable existing empirical literature studying the long-run postissue stock return performance of firms issuingequity, ordinary convertibles, and straight debt (Loughran and Ritter, 1995; Spiess and Affleck-Graves, 1995, 1999), it isindependently interesting to study the long-run postissue stock return performance of putable convertible issuers and tocompare it to the corresponding stock return performance of ordinary convertible issuers.19Investor aversion to longer bond maturities may arise from a variety of reasons. For example, the longer the matu-rity, the greater the ability of stockholders to modify corporate investment policies, thus engaging in risk-shifting orunderinvestment in order to transfer wealth from bondholders to themselves.


Second, within a sample of putable convertible issuers, it predicts that issuers of zero-couponputable convertibles will be those firms that have greater tax obligations as compared to issuers ofcoupon-bearing putable convertibles (H12). Third, since firms with higher credit ratings are likelyto have more taxable income to shelter, this hypothesis also predicts that a smaller proportion ofputable convertibles will be in the lower credit rating categories compared to ordinary convertibles(H3B).20

II. Data and Sample Selection

The data used in this study came from several different databases. The list of convertibledebt offerings was obtained from SDC/Platinum Global New Issues Database. Since the firstputable convertible debt offering was made in 1982, we restricted ourselves to a sample of firmsthat issued convertible debt from 1982-2003. After eliminating firms with no CRSP/Compustatdata available, foreign issuers, issues with poison put provisions, mandatory convertible issues,exchangeable issues, and convertible preferred stock offerings, we were left with 2,036 issues.Of these issues, 365 were putable convertible offerings and the remaining 1,671 were ordinary(nonputable) convertible offerings. Further, of the 365 putable convertible offerings, 132 werezero-coupon bonds and 233 were coupon-bearing bonds. Additionally, of the 1,671 ordinaryconvertible offerings, only 42 were zero-coupon bonds while 1,629 were coupon-bearing bonds.21

We eliminated the following issues as they are irrelevant to the objectives of our study. Poisonput issues become putable only in cases of some specific corporate events (e.g., changes in thecomposition of the firm’s board of directors, takeovers, and others). Mandatory convertibles aremandatorily convertible and can be considered as deferred equity. Exchangeable convertibles areconvertible to equity of firms other than the issuer or convertible to securities other than theequity of the issuer.

Information regarding stock prices and returns necessary to analyze announcement effects,firm valuation, and stock return performance was obtained from CRSP, while the accountinginformation necessary to study firms’ operating performance, valuation, and to calculate vari-ous financial ratios was obtained from Compustat. Convertible issue announcement dates wereobtained by searching the Factiva database maintained by the Dow Jones and Reuters Company.

III. Empirical Tests and Results

We now discuss the empirical methodology used to test our hypotheses and report results. InSection A, we present the summary statistics and results of our univariate tests comparing firmand issue characteristics of putable and ordinary convertible issuers. In Section B, we reportour results concerning the announcement effects of putable and ordinary convertible issues. In

20Of course, the tax savings hypothesis cannot provide a stand-alone explanation for the choice of firms between putableand ordinary convertibles since 64% of the putable convertibles in our sample are coupon-bearing bonds. However, thefact that 36% of putable convertibles are zero-coupon bonds (while only 2.5% of ordinary convertibles are zero-couponbonds) indicates that one has to consider tax savings as one of the possible contributing factors for the issuance of putableconvertibles.21Many zero-coupon putable convertibles are LYONs (Liquid Yield Option Notes), which are zero-coupon, putableconvertible bonds that are also callable created by Merrill Lynch White Weld Capital Markets Group in 1985. SeeMcConnell and Schwartz (1992) for a description and history of this security. However, some zero-coupon putableconvertibles in our sample are not callable and, therefore, do not fall into the category of LYONs.


Section C, we study the long-run operating performance of putable and ordinary convertibleissuers. Section D reports the results of our valuation analysis. In Section E, we present the resultsof our study of the long-run stock return performance of putable and ordinary convertible issuers.Finally, in Section F, we submit the results of logit regressions explaining the firms’ choicebetween putable and ordinary convertible issues.

A. Summary Statistics and Univariate Tests

In this section, we present the summary statistics of firm and issue characteristics of putable andordinary convertible issuers in the context of our hypotheses and report the results of univariatetests of differences in these variables between the two groups.

The risk-shifting hypothesis H1 predicts that firms with greater growth opportunities are morelikely to issue putable convertibles. Table I, reporting the summary statistics of putable andordinary convertible offerings, demonstrates that putable convertible issuers have lower levelsof capital expenditures and R&D expenses normalized by assets in the fiscal year prior to theissue when compared to ordinary convertible issuers. Putable convertible issuers’ average capitalexpenditures over assets is 6.65% and average R&D expenses over assets is 2.85%, while the sameratios for ordinary convertible issuers are significantly higher at 9.44% and 6.26%, respectively.Putable convertible issuers also have lower Q ratios measured at the end of the fiscal year priorto the issue. Q ratio (the ratio of the market value of firm’s assets to the book value of assets)is used extensively in the literature as a measure of investment opportunities (Smith and Watts,1992) and higher values of the Q ratio indicate greater investment opportunities. The average Qratio of putable convertible issuers (1.95) is significantly lower than that of ordinary convertibleissuers (2.68). Thus, we find no evidence supporting the risk-shifting hypothesis H1.

The risk-shifting hypothesis H2 predicts that smaller and riskier firms with higher leverage andgreater bankruptcy probability overall are more likely to issue putable convertibles (to minimizethe opportunity for risk-shifting by equity holders). Table I demonstrates that putable convertibleissuers are significantly larger. The mean and median book values of their assets are approximatelynine times larger than those of ordinary convertible issuers. Also, the mean and median marketvalues of equity of putable convertible issuers are approximately six times larger than thoseof ordinary convertible issuers. Additionally, putable convertible issuers are less risky firms.They have significantly lower preissue values of cash flow volatility, stock return volatility, andidiosyncratic risk as compared to ordinary convertible issuers. Next, putable convertible issuershave higher levels of leverage measured by the ratio of long-term debt over assets before theissue. However, since the ratio of total proceeds to total assets was significantly less for putableconvertible issuers, the leverage of these firms was lower after the issue. Thus, at the end ofthe fiscal year of the issue, the median leverage ratio of putable convertible issuers was 29.04%while that of ordinary convertible issuers was 34.26% with the difference being significant atthe 1% level. Finally, putable convertible issuers have a lower overall bankruptcy probability. Weestimate the bankruptcy probability by constructing a bankruptcy probability measure using themodified model of market and accounting variables suggested by Shumway (2001). In additionto accounting ratios such as those used by Altman (1968) and Zmijewski (1984), this model alsouses market driven variables such as prior market-adjusted stock return and idiosyncratic risk topredict bankruptcy.22 This measure, which we call the Shumway bankruptcy measure (SBM), iscalculated in the following way:

22Shumway (2001) indicates that the models with market driven variables predict bankruptcy probability better than thosewith the Altman (1968) and Zmijewski (1984) variables. A model with market driven variables places 75% of bankruptfirms in the highest bankruptcy decile, while models with the Altman (1968) and Zmijewski (1984) variables place only42% and 54% of bankrupt firms in the highest bankruptcy decile, respectively.


Tab

leI.

Su

mm

ary

Sta

tisti

cs

of

Pu

tab

lean

dO

rdin

ary

Co

nvert

ible

Deb

tO

fferi

ng

s

Item

sre

fer

toC

ompu

stat

data

item

sat

the

end

ofth

efi

scal

year

prio

rto

the

conv

erti

ble

issu

e.C

apit

alex

pend

itur

esar

eth

eca

pita

lexp

endi

ture

s(I

tem

128)

.R&

Dis

the

rese

arch

and

deve

lopm

ent

expe

nses

(Ite

m46

).Q

rati

ois

Tobi

n’s

Qco

mpu

ted

for

the

fisc

alye

arpr

ior

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eis

sue

asth

em

arke

tva

lue

ofas

sets

divi

ded

byth

ebo

okva

lue

ofas

sets

,w

here

the

mar

ket

valu

eof

asse

tseq

uals

the

book

valu

eof

asse

tspl

usth

em

arke

tva

lue

ofco

mm

oneq

uity

(Ite

m19

9×

Item

25)

less

the

book

valu

eof

com

mon

equi

ty(I

tem

60).

Mar

ket-

to-b

ook

isth

em

arke

tval

ueof

equi

tyov

erth

ebo

okva

lue

ofeq

uity

.Tot

alas

sets

are

the

book

valu

eof

firm

’sto

tal

asse

ts(I

tem

6).M

arke

tva

lue

ofeq

uity

isth

enu

mbe

rof

shar

esou

tsta

ndin

g(I

tem

25)

mul

tipl

ied

byth

esh

are

pric

e(I

tem

199)

.Car

dina

lize

dcr

edit

rati

ngis

the

card

inal

ized

rati

ngba

sed

onth

eco

nver

tibl

eis

sues

’S

&P

bond

rati

ngs,

whe

reA

AA

=1,

...,

and

C=

9.C

onve

rsio

npr

emiu

mis

the

perc

enta

gedi

ffer

ence

betw

een

the

issu

er’s

stoc

kpr

ice

atw

hich

the

conv

ersi

onop

tion

beco

mes

inth

em

oney

and

the

issu

er’s

stoc

kpr

ice

atth

eti

me

ofco

nver

tibl

eis

sue.

Cas

hfl

owvo

lati

lity

isth

est

anda

rdde

viat

ion

ofth

efi

rm’s

cash

flow

/tot

alas

sets

over

the

five

-yea

rpe

riod

prio

rto

the

issu

e.S

tock

retu

rnvo

lati

lity

isth

est

anda

rdde

viat

ion

ofth

eda

ilyst

ock

retu

rns

for

ape

riod

of25

5tr

adin

gda

ysen

ding

46da

ysbe

fore

the

issu

eda

te.I

dios

yncr

atic

risk

isth

ere

sidu

alst

anda

rdde

viat

ion

ofth

em

arke

tmod

eles

tim

ated

over

255

trad

ing

days

endi

ng46

days

befo

reth

eis

sue

date

.Lon

g-Te

rmD

ebti

sth

ebo

okva

lue

oflo

ng-t

erm

debt

(Ite

m9)

.Shu

mw

ayba

nkru

ptcy

mea

sure

(SB

M)

isco

mpu

ted

afte

rS

hum

way

(200

1)as

SB

M=

−1.9

82×

(RO

A)+

3.59

3×

(tot

alli

abil

itie

s(I

tem

181)

/tot

alas

sets

)−

0.46

7×

(nat

ural

loga

rith

mof

the

rati

oof

the

mar

ketv

alue

ofeq

uity

toth

eto

talm

arke

tval

ueof

equi

tyof

allC

ompu

stat

firm

s)−

1.80

9×

(one

-yea

rpri

orm

arke

t-ad

just

edcu

mul

ativ

ere

turn

)+

5.79

1×

(idi

osyn

crat

icri

sk).

Inco

me

tax

obli

gati

ons

are

the

tota

lin

com

eta

xob

liga

tion

s(I

tem

16).

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esar

eth

eto

tal

sale

s(I

tem

12).

Inve

stor

sent

imen

tind

exis

the

firs

tpri

ncip

alco

mpo

nent

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thog

onol

ized

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eigh

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aver

age

clos

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ndfu

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scou

nt,t

hena

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arit

hmof

NY

SE

shar

etu

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ded

usin

gth

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ear

mov

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age,

the

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ber

and

aver

age

firs

t-da

yre

turn

son

IPO

s,th

eeq

uity

shar

ein

new

issu

esof

equi

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dlo

ng-t

erm

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,and

the

divi

dend

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ium

defi

ned

asth

elo

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ffer

ence

betw

een

aver

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atth

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ginn

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ofth

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sue

mon

th.I

ssue

proc

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are

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ceed

sof

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issu

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ash

flow

isth

efr

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shfl

owco

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ted

asop

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me

befo

rede

prec

iati

on(I

tem

13)

min

usin

com

eta

xob

liga

tion

s(I

tem

16)

plus

the

chan

gein

defe

rred

taxe

sfr

omth

epr

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usye

arto

the

curr

enty

ear(

chan

gein

Item

35)m

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inte

rest

expe

nse

(Ite

m15

)min

usth

esu

mof

pref

erre

ddi

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nds

(Ite

m19

)and

com

mon

divi

dend

s(I

tem

21).

RO

Ais

the

retu

rnon

asse

tsco

mpu

ted

asth

era

tio

ofth

ene

tinc

ome

(Ite

m17

2)to

the

tota

lass

ets.

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-yea

rpr

ior

mar

ket-

adju

sted

cum

ulat

ive

retu

rnis

com

pute

dby

cum

ulat

ing

daily

mar

ket-

adju

sted

retu

rns

for

ape

riod

of25

5tr

adin

gda

yspr

ior

toth

eis

sue

date

.Mat

urit

yis

the

num

ber

ofye

ars

tofi

nalm

atur

ity.

The

resu

lts

oft-

test

sfo

rth

edi

ffer

ence

inm

eans

and

nonp

aram

etri

cW

ilco

xon

rank

-sum

test

sfo

rth

edi

ffer

ence

inm

edia

nsar

ere

port

edin

pare

nthe

ses.

Pu

tab

leC

on

ve

rtib

leO

rdin

ary

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nv

ert

ible

Dif

fere

nc

e(t

-Sta

tis

tic

)D

iffe

ren

ce

(z-S

tati

sti

c)

Off

eri

ng

sO

ffe

rin

gs

inM

ea

ns

inM

ed

ian

s

NM

ea

nM

ed

ian

NM

ea

nM

ed

ian

Cap

ital

expe

ndit

ures

/tot

alas

sets

(%)

333

6.65

4.46

1,37

69.

445.

99−2

.79∗∗

∗(−

4.11

)−1

.54∗∗

∗(−

4.06

)R

&D

/tot

alas

sets

(%)

342

2.85

0.00

1,47

06.

260.

00−3

.41∗∗

∗(−

3.65

)0.

00∗∗

∗(−

3.08

)Q

rati

o34

21.

951.

511,

451

2.68

1.60

−0.7

3∗∗∗

(−2.

95)

−0.1

0∗∗(−

2.20

)M

arke

t-to

-boo

k33

22.

202.

251,

330

10.1

02.

23−7

.90

(−0.

80)

0.02

(−0.

13)

Tota

lass

ets

($m

illi

on)

342

14,9

04.9

32,

016.

831,

470

1,67

5.41

228.

0813

,229

.52∗∗

∗(8

.88)

1,78

8.76

∗∗∗

(17.

40)

Mar

ketv

alue

ofeq

uity

($m

illi

on)

348

7,08

5.01

1,60

5.18

1,46

71,

299.

8123

4.91

5,78

5.19

∗∗∗

(9.7

2)1,

370.

27∗∗

∗(1

6.25

)

(Con

tinu

ed)


Tab

leI.

Su

mm

ary

Sta

tisti

cs

of

Pu

tab

lean

dO

rdin

ary

Co

nvert

ible

Deb

tO

fferi

ng

s(C

on

tin

ued

)

Pu

tab

leC

on

ve

rtib

leO

rdin

ary

Co

nv

ert

ible

Dif

fere

nc

e(t

-Sta

tis

tic

)D

iffe

ren

ce

(z-S

tati

sti

c)

Off

eri

ng

sO

ffe

rin

gs

inM

ea

ns

inM

ed

ian

s

NM

ea

nM

ed

ian

NM

ea

nM

ed

ian

Car

dina

lize

dcr

edit

rati

ng22

94.

424.

0066

55.

216.

00−0

.79∗∗

∗(−

7.63

)−2

.00∗∗

∗(−

7.62

)C

onve

rsio

npr

emiu

m(%

)33

234

.29

30.1

71,

146

23.5

822

.14

10.7

1∗∗∗

(5.8

5)8.

03∗∗

∗(1

0.22

)C

ash

flow

vola

tili

ty(%

)30

74.

382.

661,

042

7.88

3.39

−3.5

1∗∗∗

(−4.

07)

−0.7

3∗∗∗

(−3.

80)

Sto

ckre

turn

vola

tili

ty(%

)36

03.

162.

811,

552

3.68

3.15

−0.5

2∗∗∗

(−4.

54)

−0.3

4∗∗∗

(−3.

69)

Idio

sync

rati

cri

sk(%

)36

02.

872.

611,

552

3.45

2.99

−0.5

8∗∗∗

(−5.

40)

−0.3

8∗∗∗

(−4.

89)

Lon

g-te

rmde

bt/t

otal

asse

ts(%

)34

224

.82

22.7

21,

460

22.7

918

.13

2.02

(1.3

0)4.

59∗∗

∗(3

.03)

Shu

mw

ayba

nkru

ptcy

mea

sure

(SB

M)

333

6.19

6.08

1,31

26.

596.

38−0

.40∗∗

∗(−

3.25

)−0

.30∗∗

∗(−

2.94

)

Inco

me

tax

obli

gati

ons

($m

illi

on)

341

172.

7434

.61

1,46

718

.78

2.38

153.

96∗∗

∗(9

.17)

32.2

3∗∗∗

(12.

75)

Inco

me

tax

obli

gati

ons/

sale

s(%

)34

13.

602.

781,

445

2.36

1.72

1.25

∗∗∗

(3.3

7)1.

07∗∗

∗(4

.49)

Inve

stor

sent

imen

tind

ex36

5−0

.06

−0.1

41,

671

0.54

0.52

−0.6

1∗∗∗

(−13

.00)

−0.6

6∗∗∗

(−13

.35)

Issu

epr

ocee

ds($

mil

lion

)36

533

1.80

195.

601,

670

100.

7350

.00

231.

07∗∗

∗(1

7.16

)14

5.60

∗∗∗

(17.

55)

Issu

epr

ocee

ds/t

otal

asse

ts(%

)34

218

.09

10.3

81,

469

38.9

923

.78

−20.

90∗∗

∗(−

7.46

)−1

3.40

∗∗∗

(−10

.39)

Cas

hfl

ow/t

otal

asse

ts(%

)30

15.

946.

391,

166

−1.3

45.

747.

28∗∗

∗(3

.61)

0.65

∗∗∗

(3.1

3)R

OA

(%)

332

2.00

3.61

1,33

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.33

2.91

10.3

3∗∗∗

(4.3

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71∗∗

∗(3

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One

year

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rm

arke

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rn(%

)36

010

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7.39

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220

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(−4.

23)

Mat

urit

y(y

ears

)36

519

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91,

527

14.2

110

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5.77

∗∗∗

(12.

55)

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(11.

45)

∗∗∗ S

igni

fica

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the

0.01

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l.∗∗

Sig

nifi

cant

atth

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05le

vel.


SBM = −1.982 × NI

TA+ 3.593 × TL

TA− 0.467 × Relative size − 1.809 × (rit−1 − rmt−1)

+ 5.791 × Sigma, (1)

where NI is the net income (Compustat Item 172), TA is the book value of total assets (Item 6), TLis the total liabilities (Item 181), Relative size is the natural logarithm of the ratio of a firm’s marketvalue of equity (Item 199 × Item 25) to the total market value of equity of all Compustat firms,rit−1 − rmt−1 is the one-year prior market-adjusted cumulative return computed by cumulatingdaily market-adjusted returns for a period of 255 trading days prior to the issue date, and Sigma isthe idiosyncratic risk calculated as the residual standard deviation of the market model estimatedover 255 trading days ending 46 days before the issue date. All accounting variables are measuredat the end of the fiscal year prior to the issue. Higher values of SBM indicate a higher probabilityof bankruptcy. Table I indicates that both the mean and median SBM values of putable convertibleissuers are significantly lower than those of ordinary convertible issuers. These findings do notprovide support for the risk-shifting hypothesis H2, as well.

The risk-shifting hypothesis H3A predicts that a greater proportion of putable convertibleissues will be in the lower credit rating categories when compared to ordinary convertible issues,while the tax savings hypothesis H3B predicts quite the opposite. We calculate a cardinalizedmeasure of credit rating based on S&P bond ratings by assigning an AAA-rated bond a codeof one, an AA-rated bond a code of two, . . . , and a C-rated bond a code of nine. We excludeunrated issues from the construction of this measure.23 The average cardinalized credit rating ofputable convertible issues (4.42) is significantly smaller than that of ordinary convertible issues(5.21). This indicates that, on average, putable convertible issues have better credit ratings, whichcontradicts the risk-shifting hypothesis H3A and provides support for the tax savings hypothesisH3B.

The tax savings hypothesis H11 predicts that firms that have greater tax obligations are morelikely to issue putable convertibles. Table I demonstrates that putable convertible issuers havesignificantly greater tax obligations (both in absolute dollar terms, as well as normalized by sales)in the fiscal year prior to the issue when compared to ordinary convertible issuers.24 Further,the tax savings hypothesis H12 predicts that zero-coupon putable convertible issuers are morelikely to have larger tax obligations as compared to non-zero-coupon putable convertible issuers.We split putable convertible issuers into two subsamples of zero-coupon putable convertibleissuers (129 firms) and non-zero-coupon putable convertible issuers (212 firms). Zero-couponputable convertible issuers have significantly greater tax obligations in the year prior to the issuewhen compared to non-zero-coupon putable convertible issuers (both in absolute dollar terms,as well as normalized by sales). The median income tax obligations of zero-coupon putableconvertible issuers are $80.70 million while it is only $18.78 million for ordinary convertibleissuers. The median income tax obligations over sales of zero-coupon putable convertible issuersare 3.51% while it is 2.26% for ordinary convertible issuers. These differences in medians arestatistically significant at the 1% level. Thus, the above evidence provides support for the taxsavings hypotheses H11 and H12.

23There are 136 unrated putable convertible issues and 1,015 unrated ordinary convertible issues in our sample. Smallerissues are often not rated to save rating fees, even if the issue would have been rated investment grade. We thank ananonymous referee for pointing this out.24We normalize income tax obligations by sales rather than assets as income tax obligations are directly related to thelevel of sales and, to a lesser degree, to the level of assets.


We further test our hypotheses by conducting a subsample analysis. We split our sample ofconvertible issues into two equal subsamples based on various firm and issue characteristics (twosubsamples with above and below median values of such characteristics) and test the differencesin proportions of putable convertibles across the two subsamples. The results of this analysisare presented in Panel A of Table II. The proportions of putable convertible issuers in thesubsamples of convertible issuers with above median values of capital expenditures over assetsand R&D expenses over assets are significantly smaller than those in the respective subsamplesof convertible issuers with below median values of these variables.25 These findings indicate thatfirms with higher capital expenditures and R&D expenses relative to their assets are more likelyto issue ordinary convertibles rather than putable convertibles thus contradicting the risk-shiftinghypothesis H1.

Further, Panel A of Table II reports that the proportions of putable convertible issuers inthe subsamples of convertible issuers with above median values of total assets and marketvalue of equity are significantly larger than those in the respective subsamples of convertibleissuers with below median values of these variables. Also, the proportions of putable convert-ible issuers in the subsamples of convertible issuers with above median values of cash flowvolatility, stock return volatility, idiosyncratic risk, and Shumway (2001) bankruptcy measureare significantly smaller than those in the respective subsamples of convertible issuers withbelow median values of these variables. These results indicate that smaller firms, as well asthose with higher firm risk and greater bankruptcy probability, are more likely to issue ordinaryconvertibles than putable convertibles, thus providing further evidence against the risk-shiftinghypothesis H2.

Panel A of Table II also indicates that the proportion of putable convertible issues in thesubsample of convertible issues with below median values of cardinalized credit rating (bettercredit ratings) is significantly larger than that of the respective subsample of convertible issueswith above median values of this variable (worse credit ratings). We also study the distributionof credit ratings of putable and ordinary convertible issues. Panel B of Table II reports the pro-portions of putable convertible issues (as a fraction of all putable convertible issues) in eachcredit rating category (AAA, AA, . . . , and C), as well as the proportions of ordinary convertibleissues (as a fraction of all ordinary convertible issues) in each credit rating category. Panel Bof Table II indicates that the proportions of putable convertible issues in the investment-gradecategories of AAA, A, and BBB are significantly larger than those of ordinary convertible is-sues and the proportions of putable convertible issues in the speculative-grade categories of Band CCC are significantly smaller than those of ordinary convertible issues. The above find-ings provide further evidence that putable convertible issues are more likely to have highercredit ratings when compared to ordinary convertible issues. This provides support for the taxsavings hypothesis H3B, while this evidence is inconsistent with the risk-shifting hypothesisH3A.

Finally, Panel A of Table II demonstrates that the proportion of putable convertible issuers inthe subsample of convertible issuers with above median values of income tax obligations (bothin absolute dollar terms as well as normalized by sales) is significantly larger than that of therespective subsample of convertible issuers with below median values of income tax obligations.This provides further support for the tax savings hypothesis H11.

25There are 1,055 firms in our sample of convertible issuers with the ratio of R&D expenses over assets equal to zero.We place these firms in the below median R&D/assets category. The ratio of R&D expenses over assets is positive forthe rest of the sample (757 firms), which we place in the above median R&D/assets category.


Table II. Subsample Analysis of Putable and Ordinary Convertible Debt Offerings

Variables of interest are various firm and issue characteristics. Items refer to Compustat data items at theend of the fiscal year prior to the convertible issue. Capital expenditures are the capital expenditures (Item128). R&D is the research and development expenses (Item 46). Q ratio is Tobin’s Q computed for the fiscalyear prior to the issue as the market value of assets divided by the book value of assets, where the marketvalue of assets equals the book value of assets plus the market value of common equity (Item 199 × Item25) less the book value of common equity (Item 60). Total assets are the book value of the firm’s total assets(Item 6). Market value of equity is the number of shares outstanding (Item 25) times the share price (Item199). Cardinalized credit rating is the cardinalized rating based on the convertible issues’ S&P bond ratings,where AAA = 1, . . . , and C = 9. Convertible bond issues with BB or above ratings are denoted as issueswith below median cardinalized credit ratings, and issues with BBB or below ratings are denoted as issueswith above median cardinalized credit ratings. Conversion premium is the percentage difference betweenthe issuer’s stock price at which the conversion option becomes in the money and the issuer’s stock priceat the time of convertible issue. Cash flow volatility is the standard deviation of the firm’s cash flow/totalassets over the five-year period prior to the issue. Stock return volatility is the standard deviation of thedaily stock returns for a period of 255 trading days ending 46 days before the issue date. Idiosyncratic risk isthe residual standard deviation of the market model estimated over 255 trading days ending 46 days beforethe issue date. Long-term debt is the book value of long-term debt (Item 9). Shumway bankruptcy measure(SBM) is computed after Shumway (2001) as SBM = −1.982 × (ROA) + 3.593 × (total liabilities (Item181)/total assets) − 0.467 × (natural logarithm of the ratio of the market value of equity to the total marketvalue of equity of all Compustat firms) −1.809 × (one-year prior market-adjusted cumulative return) +5.791 × (idiosyncratic risk). Income tax obligations are the total income tax obligations (Item 16). Sales arethe total sales (Item 12). The results of t-tests for the difference in proportions are reported in parentheses.

Panel A. Proportions of Putable Convertible Issues Among All Convertible Issues with Above and BelowMedian Values of the Variables of Interest

Variables of Interest Proportion of Proportion of Difference in (t-Statistic)

Putable Putable Proportions

ConvertibleIssues amongAll Convertible

Issues withAbove MedianValues of theVariable of

Interest

ConvertibleIssues amongAll Convertible

Issues withBelow MedianValues of the

Variable ofInterest

N Proportion N Proportion

Capital expenditures/total assets 855 0.1637 854 0.2260 −0.0623∗∗∗ (−3.26)R&D/total assets 757 0.1678 1,055 0.2038 −0.0360∗ (−1.93)Q ratio 897 0.1773 896 0.2042 −0.0270 (−1.45)Total assets 906 0.3300 906 0.0475 0.2826∗∗∗ (16.47)Market value of equity 907 0.3197 908 0.0639 0.2559∗∗∗ (14.63)Cardinalized credit rating 427 0.1475 457 0.3632 −0.2157∗∗∗ (−7.53)Conversion premium 739 0.3099 739 0.1394 0.1705∗∗∗ (8.02)Cash flow volatility 675 0.1941 674 0.2611 −0.0671∗∗∗ (−2.94)Stock return volatility 956 0.1589 956 0.2175 −0.0587∗∗∗ (−3.29)Idiosyncratic risk 956 0.1538 956 0.2228 −0.0690∗∗∗ (−3.87)Long-term debt/total assets 901 0.2120 901 0.1676 0.0444∗∗ (2.41)Shumway bankruptcy measure 823 0.1762 822 0.2287 −0.0525∗∗∗ (−2.66)Income tax obligations 904 0.2898 904 0.0874 0.2024∗∗∗ (11.38)Income tax obligations/sales 893 0.2240 893 0.1579 0.0661∗∗∗ (3.56)

(Continued)


Table II. Subsample Analysis of Putable and Ordinary Convertible Debt Offerings

(Continued)

Panel B. Distribution of Credit Ratings of Putable and Ordinary Convertible Issues

Credit Cardinalized Putable Ordinary Difference in (t-Statistic)

Ratings Credit Convertible Convertible Proportions

Ratings Issues Issues

N Proportion N Proportion

AAA 1 5 0.0218 3 0.0046 0.0173∗∗ (2.38)AA 2 9 0.0393 16 0.0244 0.0149 (1.17)A 3 42 0.1834 62 0.0947 0.0887∗∗∗ (3.61)BBB 4 77 0.3362 122 0.1863 0.1500∗∗∗ (4.73)BB 5 33 0.1441 88 0.1344 0.0098 (0.37)B 6 54 0.2358 298 0.4550 −0.2192∗∗∗ (−5.94)CCC 7 7 0.0306 58 0.0885 −0.0580∗∗∗ (−2.90)CC 8 1 0.0044 3 0.0046 −0.0002 (−0.04)C 9 1 0.0044 5 0.0076 −0.0033 (−0.52)

Total 229 1 655 1

∗∗∗Significant at the 0.01 level.∗∗Significant at the 0.05 level.∗Significant at the 0.10 level.

B. The Announcement Effects of Putable and Ordinary Convertible Issues

In this section, we study the announcement effects of convertible debt issues and empiricallytest hypotheses H4A, H4B, and H7. The risk-shifting hypothesis H4A predicts no difference inthe announcement effects across putable and ordinary convertible issues, whereas the asymmetricinformation hypothesis H4B predicts that the announcement effects of putable convertible issueson the issuers’ equity will be more favorable (less negative) when compared to that of matchedordinary convertible issues.

For public issues, the announcement date was taken to be the earliest of the filing date or thedate of the first news article regarding the issue in the news media. For private placements, theannouncement date was taken to be the earliest date of the first news article regarding the issuein the news media or the issue date. The announcement effect for each firm was computed asthe cumulative abnormal return (CAR) for a particular event window around the announcementdate. Daily abnormal returns were computed using the market model (with value- and equallyweighted CRSP indices). Market model parameters were estimated over 255 trading days ending46 trading days before the offering announcement with at least 100 daily returns in the estimationperiod. Announcement effects were calculated for six different event windows for each marketindex ranging from three days before to three days after the announcement date.

There are substantial differences in the types of firms issuing putable and ordinary convertibledebt (recall that from the summary statistics, putable convertible issuers are much larger firmswith better performance).26 Such differences can greatly influence the announcement effect.Another aspect that can potentially have an impact on the announcement effect is the type of issue

26Table I indicates that the operating performance of putable convertible issuers measured by the return on assets (ROA)in the fiscal year prior to the issue is significantly better than that of ordinary convertible issuers.


(public offering or private placement).27 In order to account for such differences, we compare theannouncement effects of putable convertible issues with those of a matched sample of ordinaryconvertible issues. In our context, it is difficult to implement a standard matching algorithm (see,e.g., Loughran and Ritter, 1997) and directly match each putable convertible issue to an ordinaryconvertible issue by firm size, prior performance, industry, type of issue, and year of issue since itis impossible to find such a match within a reasonable size range. Therefore, we use the propensityscore matching technique to find a match for each putable convertible issue. This technique hasa number of advantages. First, no constraints need to be imposed on matching variables. Second,a large number of matching variables can be used. Finally, this technique produces accurateestimates in a setting where the event group significantly differs from the population of potentialmatches (Dehejia and Wahba, 2002).28

We use a modified version of the “nearest match” propensity score matching algorithm similarto the one used by Hillion and Vermaelen (2004). Let Xi,j be a vector of independent characteristicsobserved for firm i (putable convertible issuers as well as ordinary convertible issuers) in fiscalyear j prior to the issue. The set of the factors Xi,j for firm i in year j consists of the following:[operating income before depreciation (OIBD) + interest income (Compustat Item 13 + Item62)]/Assets (Item 6), profit margin [net income (Item 172)/sales (Item 12)], return on assets (netincome/assets), (OIBD + interest income)/sales, [capital expenditures + R&D (Item 128 + Item46)]/assets, market-to-book [(number of shares outstanding (Item 54) times share price (Item199)/book value of equity (Item 60)], assets, and a set of two-digit SIC code industry dummies.Let Di,j be a dummy that is equal to one for putable convertible issuers and zero for ordinaryconvertible issuers. We estimate the propensity score logit function as Pi,j = P(Di,j = 1|Xi,j)for all issues from 1982-2003. With the estimated propensity scores Pi,j, we match each putableconvertible issuer to a single ordinary convertible issuer with the closest Pi,j score within thesame year of issue and within the same type of issue (public vs. private placements). If we do notfind a match within the year of issue, we search for a potential match in the two years prior to theissue year.

Table III presents the announcement effects of putable convertible issues and matched ordi-nary convertible issues. The results indicate that putable convertible issues have less negativeannouncement effects in all event windows with the differences being statistically significant forthe windows of 0 to +1 day, −3 to +3 days, and 0 to +3 days around the announcement date.These results broadly support the asymmetric information hypothesis H4B and are inconsistentwith the risk-sifting hypothesis H4A.

Next, we test the asymmetric information hypothesis H7, which predicts that the announcementeffects of putable convertible issues with a high conversion premium relative to a matched set ofordinary convertible issues will be more favorable than those of putable convertible issues with alow conversion premium relative to a matched set of ordinary convertible issues. Table IV reportsthat the average announcement effect of putable convertible issues with a high (above median)conversion premium is significantly less negative that that of matched ordinary convertibleissues. The differences in the means between these two groups are highly significant for all event

27See Hertzel and Smith (1993) who document positive announcement effects for private equity placements and Asquithand Mullins (1986), Masulis and Korwar (1986), and Mikkelson and Partch (1986) who document negative announcementeffects for public equity offerings.28The propensity score matching method has already been used in the finance literature to pair-match companies basedon a given set of characteristics. In particular, Villalonga (2004) uses the propensity score matching method in her studyof the diversification discount to find appropriate benchmark companies for diversifying firms. Hillion and Vermaelen(2004) apply propensity score matching in their study of the operating performance of companies issuing floating-pricedconvertibles.


Tab

leIII.

An

no

un

cem

en

tE

ffects

of

Pu

tab

lean

dO

rdin

ary

Co

nvert

ible

Issu

es

Ann

ounc

emen

tef

fect

for

each

issu

eis

com

pute

das

the

cum

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ive

abno

rmal

retu

rn(C

AR

)fo

ra

part

icul

arw

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ound

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unce

men

tda

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lyab

norm

alre

turn

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elfo

rtw

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arke

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ices

:1)t

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lue-

wei

ghte

d(V

W)

and

2)eq

ually

wei

ghte

d(E

W)C

RS

Pin

dice

s.M

arke

tm

odel

para

met

ers

are

esti

mat

edov

er25

5tr

adin

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ding

46tr

adin

gda

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tw

ith

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100

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nver

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Ta

ble

IV.

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ve

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Sp

lit

by

Co

nv

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Pre

miu

m

Ann

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ectf

orea

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isco

mpu

ted

asth

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mul

ativ

eab

norm

alre

turn

(CA

R)

for

apa

rtic

ular

win

dow

arou

ndth

ean

noun

cem

entd

ate

ofth

eof

feri

ng.D

aily

abno

rmal

retu

rns

are

com

pute

dus

ing

the

mar

ketm

odel

for

two

mar

keti

ndic

es:1

)th

eva

lue-

wei

ghte

d(V

W)

and

2)eq

ually

wei

ghte

d(E

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CR

SP

indi

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Mar

ketm

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inth

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oney

and

the

issu

er’s

stoc

kpr

ice

atth

eti

me

ofco

nver

tibl

eis

sue.

Eac

hpu

tabl

eco

nver

tibl

eis

suer

ism

atch

edw

ith

anor

dina

ryco

nver

tibl

eis

suer

usin

gth

epr

open

sity

scor

em

atch

ing

algo

rith

m.P

rope

nsit

ysc

ores

are

esti

mat

edba

sed

onth

epr

evio

usfi

scal

year

’s(O

IBD

+in

tere

stin

com

e)/t

otal

asse

ts,p

rofi

tmar

gin,

RO

A,

(OIB

D+

inte

rest

inco

me)

/sal

es,

(cap

ital

expe

ndit

ures

+R

&D

)/to

tal

asse

ts,

mar

ket-

to-b

ook,

tota

las

sets

,an

da

set

oftw

o-di

git

SIC

code

s.T

hepr

open

sity

scor

elo

git

func

tion

ises

tim

ated

usin

gal

liss

ues

and

am

atch

ing

ordi

nary

conv

erti

ble

issu

eris

sele

cted

toha

veth

ecl

oses

tpro

pens

ity

scor

ew

ithi

nth

esa

me

type

ofis

sue

(pub

lic

orpr

ivat

epl

acem

ent)

and

inth

esa

me

year

ofth

eis

sue

asth

epu

tabl

eco

nver

tibl

eis

suer

.If

apr

oper

mat

chis

notf

ound

inth

eye

arof

the

issu

ew

ithi

nth

esa

me

type

ofis

sue,

the

mat

chin

gor

dina

ryco

nver

tibl

eis

suer

isse

lect

edfr

omth

epr

evio

ustw

oye

ars.

The

resu

lts

oft-

test

sfo

rth

edi

ffer

ence

inm

eans

are

repo

rted

inpa

rent

hese

s.

Win

do

wP

uta

ble

Co

nv

ert

ible

Pu

tab

leC

on

ve

rtib

le(5

)D

iffe

ren

ce

(t-

(6)

Dif

fere

nc

e(t

-D

iffe

ren

ce

(t-

Iss

ue

sw

ith

Iss

ue

sw

ith

inM

ea

ns

Sta

tis

tic

)in

Me

an

sS

tati

sti

c)

inM

ea

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tati

sti

c)

Ab

ov

eM

ed

ian

Be

low

Me

dia

n(%

)(%

)D

iffe

ren

ce

sC

on

ve

rsio

nP

rem

ium

Co

nv

ers

ion

Pre

miu

m(1

)-(2

)(3

)-(4

)(%

)(5

)-(6

)

(1)

Pu

tab

le(2

)M

atc

he

d(3

)P

uta

ble

(4)

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tch

ed

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nv

ert

ible

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ina

ryC

on

ve

rtib

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rdin

ary

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ve

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leIs

su

es

Co

nv

ert

ible

Iss

ue

sIs

su

es

Me

an

(%)

Me

an

(%)

Me

an

(%)

Me

an

(%)

VW

−1to

0−1

.22

−2.1

0−1

.28

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00.

88(1

.25)

−0.4

8(−

0.86

)1.

36(1

.51)

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−1to

0−1

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10.

77(1

.09)

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3(−

0.57

)1.

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.21)

VW

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+1−3

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1−2

.92

−2.2

72.

18∗∗

∗(2

.82)

−0.6

5(−

0.98

)2.

82∗∗

∗(2

.77)

EW

−1to

+1−4

.06

−6.1

6−3

.04

−2.6

72.

10∗∗

∗(2

.76)

−0.3

7(−

0.56

)2.

46∗∗

(2.4

5)V

W0

to+1

−3.5

5−5

.88

−3.1

3−2

.58

2.34

∗∗∗

(3.4

6)−0

.55

(−0.

93)

2.88

∗∗∗

(3.2

2)E

W0

to+1

−3.9

6−6

.29

−3.2

6−2

.89

2.33

∗∗∗

(3.5

0)−0

.38

(−0.

65)

2.70

∗∗∗

(3.0

6)V

W−3

to0

−0.5

2−1

.97

−1.2

4−0

.53

1.45

(1.6

3)−0

.71

(−0.

94)

2.16

∗(1

.85)

EW

−3to

0−1

.44

−2.8

2−1

.40

−0.8

61.

38(1

.57)

−0.5

5(−

0.72

)1.

92∗

(1.6

6)V

W−3

to+3

−2.6

5−6

.22

−2.9

0−2

.51

3.56

∗∗∗

(3.3

7)−0

.39

(−0.

43)

3.95

∗∗∗

(2.8

6)E

W−3

to+3

−4.1

5−7

.53

−3.1

4−3

.33

3.38

∗∗∗

(3.1

1)0.

19(0

.21)

3.19

∗∗(2

.25)

VW

0to

+3−3

.47

−6.6

2−3

.16

−3.1

03.

15∗∗

∗(3

.63)

−0.0

6(−

0.08

)3.

21∗∗

∗(2

.80)

EW

0to

+3−4

.27

−7.2

7−3

.30

−3.7

03.

00∗∗

∗(3

.32)

0.40

(0.5

3)2.

60∗∗

(2.2

0)N

144

144

143

143

∗∗∗ S

igni

fica

ntat

the

0.01

leve

l.∗∗

Sig

nifi

cant

atth

e0.

05le

vel.

∗ Sig

nifi

cant

atth

e0.

10le

vel.


windows, except for the −1 to 0 and −3 to 0 windows. The average announcement effect ofputable convertible issues with a low (below median) conversion premium is more negative thanthat of matched ordinary convertible issues; however, the differences in the means between thesetwo groups are not statistically significant. Finally, the differences in the average announcementeffects of putable convertible issues with a high conversion premium relative to matched ordinaryconvertible issues are significantly larger than similar differences for putable convertible issueswith a low (below median) conversion premium relative to matched ordinary convertible issues.This difference in differences is statistically significant for all event windows, except for the −1to 0 window. The above findings provide support for the asymmetric information hypothesis H7.

C. The Long-Term Operating Performance of Putable and Ordinary

Convertible Issuers

In this section, we examine the long-run operating performance of putable and ordinary con-vertible issuers after the issue and test hypotheses H6A, H6B, and H9. The risk-shifting hypothesisH6A predicts no difference in the postissue operating performance of putable convertible issuersversus ordinary convertible issuers, while the asymmetric information hypothesis H6B predictsthat the postissue operating performance of putable convertible issuers will be better than that ofordinary convertible issuers.

It is problematic to directly compare putable convertible issuers with ordinary convertibleissuers due to substantial differences in size and preissue performance of the two groups asdocumented in our summary statistics. One solution is to match each putable convertible issuerwith an ordinary convertible issuer in the same industry with similar size and performance.However, as discussed in the previous section, it is impossible to find a proper match for eachputable convertible issuer among ordinary convertible issuers within the year of issue and in thesame industry within a reasonable size range. Therefore, we follow Loughran and Ritter (1997)and select a matching nonissuing firm for each convertible issuer. We then compare the relativeperformance of putable convertible issuers with respect to their nonissuing matched firms withthe relative performance of ordinary convertible issuers with respect to their matched nonissuingfirms.29 The matching algorithm used is as follows. Each issuing firm is matched with nonissuingfirms that have not issued convertible debt during the five years prior to the issue date. Thesematching nonissuers have to be in the same industry (using two-digit SIC codes) with assetsize at the end of the fiscal year prior to the issue between 25% and 200% of the issuing firm.The nonissuer with the closest operating income before depreciation (OIBD) relative to assets isthen chosen as the unique matching firm. If no nonissuer meets these criteria, then the industryrequirement is dropped and a matching firm is chosen with an asset size within 90%-110% ofthe issuing firm and with the closest, but higher, OIBD/assets ratio. If a matched firm does nothave accounting data for a particular year, we replace it with the next closest match. We usethree measures of operating performance: 1) OIBD/assets, 2) ROA, and 3) profit margin, whereOIBD is the operating income before depreciation plus interest income (Compustat Items 13 +15), assets are the book value of assets (Item 6), ROA is the return on assets (net income (Item172)/assets), and profit margin is net income/sales (Item 12).

Panel A of Table V presents the median operating performance ratios of putable convertibleissuers, their matched nonissuers, and the median differences between the performance ratios of

29This “difference in difference” methodology yields closer matches than the propensity score methodology used inour study of announcement effects in the previous section. Clearly, we could not implement this methodology forour comparison of the announcement effects of putable and ordinary convertible issues as such a comparison can beimplemented only across samples of issuing firms.


Tab

leV

.P

osti

ssu

eO

pera

tin

gP

erf

orm

an

ce

of

Pu

tab

lean

dO

rdin

ary

Co

nvert

ible

Issu

ers

Rela

tive

toM

atc

hed

No

nis

su

ers

The

Com

pust

atda

tait

ems

for

the

perf

orm

ance

vari

able

sar

eop

erat

ing

inco

me

befo

rede

prec

iati

on/a

sset

s[O

IBD

+in

tere

stin

com

e(I

tem

s13

+62

)/to

tala

sset

s(I

tem

6)],

retu

rnon

asse

ts[n

etin

com

e(I

tem

172)

/tot

alas

sets

(Ite

m6)

],an

dpr

ofit

mar

gin

[net

inco

me

(Ite

m17

2)/s

ales

(Ite

m12

)].Y

ear

0is

the

fisc

alye

arof

the

issu

e.M

atch

edno

niss

uers

are

chos

enfo

llow

ing

the

Lou

ghra

nan

dR

itte

r(1

997)

mat

chin

gal

gori

thm

.Eac

his

suin

gfi

rmis

mat

ched

wit

ha

firm

that

has

not

issu

edco

nver

tibl

ede

btdu

ring

the

five

year

spr

ior

toth

eis

sue

date

.The

noni

ssue

rha

dto

bein

the

sam

ein

dust

ry(u

sing

two-

digi

tS

ICco

des)

wit

has

set

size

atth

een

dof

the

prev

ious

fisc

alye

arre

lativ

eto

the

issu

eye

arfr

om25

%-2

00%

ofth

eis

suin

gfi

rm,a

ndth

enth

eno

niss

uer

wit

hth

ecl

oses

top

erat

ing

inco

me

befo

rede

prec

iati

on(O

IBD

)re

lativ

eto

asse

tsw

asch

osen

.If

nono

niss

uer

met

thes

ecr

iter

ia,t

hen

the

indu

stry

requ

irem

ent

was

drop

ped

and

am

atch

ing

firm

was

chos

enw

ith

anas

set

size

wit

hin

90%

-110

%of

the

issu

ing

firm

and

wit

hth

ecl

oses

t,bu

thi

gher

,O

IBD

/ass

ets

rati

o.M

edia

ndi

ffer

ence

sar

eth

em

edia

nsof

the

diff

eren

ces

betw

een

the

perf

orm

ance

rati

osof

conv

erti

bles

issu

ers

and

mat

ched

noni

ssue

rs.

Pane

lC

repo

rts

the

z-st

atis

tics

test

ing

whe

ther

the

year

lydi

stri

buti

ons

ofth

edi

ffer

ence

sin

oper

atin

gpe

rfor

man

cera

tios

(fro

mre

spec

tive

mat

ched

noni

ssue

rs)

ofpu

tabl

eco

nver

tibl

eis

suer

san

dor

dina

ryco

nver

tibl

eis

suer

sar

eeq

ualu

sing

the

Wil

coxo

ntw

o-sa

mpl

era

nk-s

umte

st.

Fis

ca

lY

ea

rN

um

be

rO

IBD

/R

OA

Pro

fit

OIB

D/

RO

AP

rofi

tO

IBD

/R

OA

Pro

fit

Re

lati

ve

too

fF

irm

sA

ss

ets

(%)

Ma

rgin

As

se

ts(%

)M

arg

inA

ss

ets

(%)

Ma

rgin

Off

eri

ng

(%)

(%)

(%)

(%)

(%)

(%)

Pane

lA.M

edia

nO

pera

ting

Perf

orm

ance

Rat

ios

ofP

utab

leC

onve

rtib

leIs

suer

s,M

atch

edN

onis

suer

s,an

dM

edia

nsof

the

Dif

fere

nces

betw

een

the

Perf

orm

ance

Rat

ios

ofP

utab

leC

onve

rtib

leIs

suer

san

dM

atch

edN

onis

suer

s

Pu

tab

leC

on

ve

rtib

leIs

su

er

Me

dia

ns

Ma

tch

ed

No

nis

su

er

Me

dia

ns

Me

dia

nD

iffe

ren

ce

s

030

811

.63

3.42

4.48

11.2

52.

933.

450.

170.

030.

65∗∗

+128

911

.62

2.99

4.22

11.4

63.

484.

33−0

.19

−0.2

90.

63+2

255

11.6

03.

334.

6411

.18

3.32

3.84

0.25

0.11

0.69

∗

+323

212

.43

3.71

4.79

11.6

94.

304.

910.

19−0

.17

0.45

+420

812

.20

4.37

5.72

12.4

84.

785.

32−0

.46

−0.2

01.

45∗∗

(Con

tinu

ed)


Tab

leV

.P

osti

ssu

eO

pera

tin

gP

erf

orm

an

ce

of

Pu

tab

lean

dO

rdin

ary

Co

nvert

ible

Issu

ers

Rela

tive

toM

atc

hed

No

nis

su

ers

(Co

nti

nu

ed)

Fis

ca

lY

ea

rN

um

be

rO

IBD

/R

OA

Pro

fit

OIB

D/

RO

AP

rofi

tO

IBD

/R

OA

Pro

fit

Re

lati

ve

too

fF

irm

sA

ss

ets

(%)

Ma

rgin

As

se

ts(%

)M

arg

inA

ss

ets

(%)

Ma

rgin

Off

eri

ng

(%)

(%)

(%)

(%)

(%)

(%)

Pane

lB.M

edia

nO

pera

ting

Perf

orm

ance

Rat

ios

ofO

rdin

ary

Con

vert

ible

Issu

ers,

Mat

ched

Non

issu

ers,

and

Med

ians

ofth

eD

iffe

renc

esbe

twee

nth

ePe

rfor

man

ceR

atio

sof

Ord

inar

yC

onve

rtib

leIs

suer

san

dM

atch

edN

onis

suer

s

Ord

ina

ryC

on

ve

rtib

leIs

su

er

Me

dia

ns

Ma

tch

ed

No

nis

su

er

Me

dia

ns

Me

dia

nD

iffe

ren

ce

s

01,

227

9.66

2.33

2.87

10.3

42.

662.

41−1

.21∗∗

∗−0

.80∗∗

0.54

+11,

110

9.57

1.88

2.43

10.7

42.

892.

62−1

.14∗∗

∗−1

.17∗∗

∗−0

.04∗∗

+299

99.

281.

262.

0210

.87

3.18

2.63

−1.4

5∗∗∗

−1.7

4∗∗∗

−0.7

9∗∗∗

+388

810

.28

2.13

2.83

11.1

33.

092.

91−1

.19∗

−0.9

7∗∗∗

−0.0

7+4

817

10.2

61.

962.

5711

.25

2.98

3.07

−1.1

8∗∗−0

.71∗

−0.3

4

Pane

lC.z

-Sta

tist

ics

Test

ing

the

Equ

alit

yof

Dis

trib

utio

nsof

the

Dif

fere

nces

inO

pera

ting

Perf

orm

ance

Rat

ios

ofP

utab

lean

dO

rdin

ary

Con

vert

ible

Issu

ers

Fis

ca

lY

ea

rR

ela

tiv

eto

Off

eri

ng

OIB

D/A

ss

ets

RO

AP

rofi

tM

arg

in

02.

69∗∗

∗2.

40∗∗

1.26

+11.

351.

85∗

1.60

+23.

20∗∗

∗4.

07∗∗

∗3.

04∗∗

∗

+31.

411.

68∗

1.55

+40.

731.

382.

18∗∗

∗∗∗ S

igni

fica

ntat

the

0.01

leve

l.∗∗

Sig

nifi

cant

atth

e0.

05le

vel.

∗ Sig

nifi

cant

atth

e0.

10le

vel.


putable convertible issuers and nonissuing matched firms. The performance of putable convertibleissuers is very similar to that of their respective matches except for the profit margin that is higherfor putable convertible issuers in Years 0, +2, and +4. Panel B of Table V reports the medianoperating performance ratios of ordinary convertible issuers, their matched nonissuers, and themedian differences between the two groups. Ordinary convertible issuers tend to underperformtheir respective matches in the years after the issue. Panel C of Table V presents z-statistics testingwhether the yearly distribution of the differences in operating performance ratios from nonissuingmatched firms are equal for putable and ordinary convertible issuers using the Wilcoxon twosample rank-sum test. For the year of the issue and the following four years, the z-statistics arepositive for all three measures indicating that the performance of putable convertible issuers(relative to their matched nonissuers) is better than that of ordinary convertible issuers (relativeto their matched nonissuers). The results are significant for the OIBD/assets measure for Years 0and +2, for the ROA measure for Years 0, +1, +2, and +3, and for the profit margin measure forYears +2 and +4. These results indicate that in the years after the issue, putable convertible issuersperform better (relative to their respective matched nonissuing firms) than ordinary convertibleissuers (relative to their respective matched nonissuing firms) consistent with the asymmetricinformation hypothesis H6B and inconsistent with the risk-shifting hypothesis H6A.30

Next, we test the asymmetric information hypothesis H9, which predicts that the postissueoperating performance of firms issuing putable convertibles with a high conversion premiumwill be better than that of firms issuing putable convertibles with a low conversion premium.Panel A of Table VI presents the median operating performance ratios of firms issuing putableconvertibles with a high (above median) conversion premium, their matched nonissuers, and themedian differences between the two groups. The performance of firms issuing putable convertibleswith a high conversion premium is very similar to that of their respective matches except forthe profit margin that is higher for putable convertible issuers in Years +3 and +4. Panel B ofTable VI reports the median operating performance ratios of firms issuing putable convertibleswith a low (below median) conversion premium, their matched nonissuers, and the mediandifferences between the two groups. The performance of firms issuing putable convertibles witha low conversion premium is very similar to that of their respective matches as well except forthe ROA that is lower for putable convertible issuers in Year +3 and the profit margin that ishigher for putable convertible issuers in Year 0. Panel C of Table VI presents z-statistics testingwhether the yearly distribution of the differences in operating performance ratios from nonissuingmatched firms are equal for firms issuing putable convertibles with a high and a low conversionpremium using the Wilcoxon two-sample rank-sum test. The z-statistics are mostly positive forall three measures and are significantly positive for the ROA and profit margin measures for Year+3. These results provide some indication that firms issuing putable convertibles with a highconversion premium perform better (relative to their respective matched nonissuing firms) thanfirms issuing putable convertibles with a low conversion premium (relative to their respectivematched nonissuing firms).

Further, Panels D and E of Table VI present z-statistics testing whether the yearly distributionof the differences in operating performance ratios from nonissuing matched firms are equal forfirms issuing putable convertibles with a high conversion premium and ordinary convertible

30As a robustness check, we also study the long-run operating performance of convertible issuers relative to propensityscore matched nonissuers (matching performed similar to that described in the announcement effects section of thispaper). The results of our long-run operating performance study of convertible issuers relative to a propensity scorematched sample of nonissuers were very similar to our results based on the matching algorithm of Loughran and Ritter(1997) that are presented here. For the sake of brevity, we do not present these results.


Tab

leV

I.P

osti

ssu

eO

pera

tin

gP

erf

orm

an

ce

of

Pu

tab

leC

on

vert

ible

Issu

ers

wit

hA

bo

ve-

an

dB

elo

w-M

ed

ian

Co

nvers

ion

Pre

miu

mR

ela

tive

toM

atc

hed

No

nis

su

ers

The

Com

pust

atda

tait

ems

for

the

perf

orm

ance

vari

able

sar

eop

erat

ing

inco

me

befo

rede

prec

iati

on/a

sset

s[O

IBD

+in

tere

stin

com

e(I

tem

s13

+62

)/as

sets

(Ite

m6)

],re

turn

onas

sets

[net

inco

me

(Ite

m17

2)/a

sset

s(I

tem

6)],

and

prof

itm

argi

n[n

etin

com

e(I

tem

172)

/sal

es(I

tem

12)]

.Yea

r0

isth

efi

scal

year

ofth

eis

sue.

Con

vers

ion

prem

ium

isth

epe

rcen

tage

diff

eren

cebe

twee

nth

eis

suer

’sst

ock

pric

eat

whi

chth

eco

nver

sion

opti

onbe

com

esin

the

mon

eyan

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suer

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ock

pric

eat

the

tim

eof

conv

erti

ble

issu

e.M

atch

edno

niss

uers

are

chos

enfo

llow

ing

the

Lou

ghra

nan

dR

itte

r(19

97)m

atch

ing

algo

rith

m.E

ach

issu

ing

firm

ism

atch

edw

ith

afi

rmth

atha

sno

tiss

ued

conv

erti

ble

debt

duri

ngth

efi

veye

ars

prio

rto

the

issu

eda

te.T

heno

niss

uer

had

tobe

inth

esa

me

indu

stry

(usi

ngtw

o-di

gitS

ICco

des)

wit

hth

eas

sets

ize

atth

een

dof

the

prev

ious

fisc

alye

arre

lativ

eto

the

issu

eye

arfr

om25

%to

200%

ofth

eis

suin

gfi

rm,a

ndth

enth

eno

niss

uer

wit

hth

ecl

oses

tope

rati

ngin

com

ebe

fore

depr

ecia

tion

(OIB

D)

rela

tive

toas

sets

was

chos

en.I

fno

noni

ssue

rm

etth

ese

crit

eria

,the

nth

ein

dust

ryre

quir

emen

twas

drop

ped

and

am

atch

ing

firm

was

chos

enw

ith

anas

set

size

wit

hin

90%

-110

%of

the

issu

ing

firm

and

wit

hcl

oses

t,bu

thi

gher

,OIB

D/a

sset

sra

tio.

Med

ian

diff

eren

ces

are

the

med

ians

ofth

edi

ffer

ence

sbe

twee

nth

epe

rfor

man

cera

tios

ofco

nver

tibl

esis

suer

san

dm

atch

edno

niss

uers

.Pa

nels

C,

D,

and

Ere

port

the

z-st

atis

tics

test

ing

whe

ther

the

year

lydi

stri

buti

ons

ofth

edi

ffer

ence

sin

oper

atin

gpe

rfor

man

cera

tios

(fro

mre

spec

tive

mat

ched

noni

ssue

rs)

ofpu

tabl

eco

nver

tibl

eis

suer

sw

ith

abov

ean

dbe

low

med

ian

conv

ersi

onpr

emiu

man

dor

dina

ryco

nver

tibl

eis

suer

sar

eeq

ualu

sing

the

Wil

coxo

ntw

o-sa

mpl

era

nk-s

umte

st.

Fis

ca

lY

ea

rN

um

be

rO

IBD

/R

OA

Pro

fit

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D/

RO

AP

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tO

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/R

OA

Pro

fit

Re

lati

ve

too

fF

irm

sA

ss

ets

(%)

Ma

rgin

As

se

ts(%

)M

arg

inA

ss

ets

(%)

Ma

rgin

Off

eri

ng

(%)

(%)

(%)

(%)

(%)

(%)

Pu

tab

leC

on

ve

rtib

leIs

su

er

Me

dia

ns

Ma

tch

ed

No

nis

su

er

Me

dia

ns

Me

dia

nD

iffe

ren

ce

s

Pane

lA.M

edia

nO

pera

ting

Perf

orm

ance

Rat

ios

ofP

utab

leC

onve

rtib

leIs

suer

sw

ith

Abo

ve-M

edia

nC

onve

rsio

nP

rem

ium

,Mat

ched

Non

issu

ers,

and

Med

ians

ofth

eD

iffe

renc

esbe

twee

nth

ePe

rfor

man

ceR

atio

sof

The

seP

utab

leC

onve

rtib

leIs

suer

san

dM

atch

edN

onis

suer

s

014

510

.23

3.42

4.68

10.3

92.

783.

94−0

.09

−0.1

50.

26+1

133

11.5

63.

675.

2411

.26

3.43

4.64

−0.1

3−0

.47

0.23

+210

713

.48

4.97

6.45

11.3

23.

725.

360.

000.

321.

06+3

9512

.60

4.76

6.36

11.7

04.

785.

760.

230.

201.

31∗∗

+484

12.0

74.

967.

4412

.24

4.37

5.64

0.66

0.42

2.19

∗

Pane

lB.M

edia

nO

pera

ting

Perf

orm

ance

Rat

ios

ofP

utab

leC

onve

rtib

leIs

suer

sw

ith

Bel

ow-M

edia

nC

onve

rsio

nP

rem

ium

,Mat

ched

Non

issu

ers,

and

Med

ians

ofth

eD

iffe

renc

esbe

twee

nth

ePe

rfor

man

ceR

atio

sof

The

seP

utab

leC

onve

rtib

leIs

suer

san

dM

atch

edN

onis

suer

s

013

511

.66

3.20

3.96

11.7

92.

963.

130.

270.

410.

70∗∗

+112

911

.79

2.76

3.22

12.0

03.

393.

83−0

.41

−0.2

70.

77+2

122

10.8

92.

873.

6511

.86

2.87

2.96

0.01

−0.1

3−0

.39

+311

512

.26

3.08

3.89

12.2

44.

304.

570.

09−0

.73∗

−1.4

2+4

105

12.7

84.

314.

7213

.33

4.92

4.55

−1.2

7−0

.87

0.74

(Con

tinu

ed)


Tab

leV

I.P

osti

ssu

eO

pera

tin

gP

erf

orm

an

ce

of

Pu

tab

leC

on

vert

ible

Issu

ers

wit

hA

bo

ve-

an

dB

elo

w-M

ed

ian

Co

nvers

ion

Pre

miu

mR

ela

tive

toM

atc

hed

No

nis

su

ers

(Co

nti

nu

ed)

Fis

ca

lY

ea

rR

ela

tiv

eto

Off

eri

ng

OIB

D/A

ss

ets

RO

AP

rofi

tM

arg

in

Pane

lC.z

-Sta

tist

ics

Test

ing

the

Equ

alit

yof

Dis

trib

utio

nsof

the

Dif

fere

nces

inO

pera

ting

Perf

orm

ance

Rat

ios

ofP

utab

leC

onve

rtib

leIs

suer

sw

ith

Abo

vean

dB

elow

-Med

ian

Con

vers

ion

Pre

miu

m

0−0

.69

−1.0

8−1

.30

+10.

36−0

.37

−0.4

5+2

0.10

1.01

0.58

+30.

501.

83∗

2.33

∗∗

+40.

270.

920.

55

Pane

lD.z

-Sta

tist

ics

Test

ing

the

Equ

alit

yof

Dis

trib

utio

nsof

the

Dif

fere

nces

inO

pera

ting

Perf

orm

ance

Rat

ios

ofP

utab

leC

onve

rtib

leIs

suer

sw

ith

Abo

ve-M

edia

nC

onve

rsio

nP

rem

ium

and

Ord

inar

yC

onve

rtib

leIs

suer

s

01.

461.

13−0

.10

+11.

061.

060.

74+2

2.14

∗∗3.

42∗∗

∗2.

25∗∗

+31.

181.

95∗

2.16

∗∗

+40.

581.

541.

83∗

Pane

lE.z

-Sta

tist

ics

Test

ing

the

Equ

alit

yof

Dis

trib

utio

nsof

the

Dif

fere

nces

inO

pera

ting

Perf

orm

ance

Rat

ios

ofP

utab

leC

onve

rtib

leIs

suer

sw

ith

Bel

ow-M

edia

nC

onve

rsio

nP

rem

ium

and

Ord

inar

yC

onve

rtib

leIs

suer

s

02.

07∗∗

2.26

∗∗1.

41+1

0.77

1.31

1.20

+22.

10∗∗

2.42

∗∗1.

76∗

+30.

59−0

.08

−0.5

3+4

0.36

0.57

1.28

∗∗∗ S

igni

fica

ntat

the

0.01

leve

l.∗∗

Sig

nifi

cant

atth

e0.

05le

vel.

∗ Sig

nifi

cant

atth

e0.

10le

vel.


issuers (Panel D) and for firms issuing putable convertibles with a low conversion premium andordinary convertible issuers (Panel E) using the Wilcoxon two sample rank-sum test. The resultsin Panels D and E of Table VI indicate that in the years after the issue, firms issuing putableconvertibles with a high conversion premium perform better than ordinary convertible issuers inYears +2 (according to all three measures), +3 (according to the ROA and profit margin), and +4(according to profit margin). Firms issuing putable convertibles with a low conversion premiumperform better than ordinary convertible issuers in Year +2 only (according to all three measures).These results again indicate that the postissue operating performance of firms issuing putableconvertibles with a high conversion premium (relative to their matched nonissuers) is somewhatbetter than that of firms issuing putable convertibles with a low conversion premium (relativeto their matched nonissuers), thus providing weak evidence consistent with the asymmetricinformation hypothesis H9.

D. The Valuation of Putable and Ordinary Convertible Issuers

In this section, we study the extent of under- or overvaluation of putable and ordinary convertibleissuers in the equity market relative to their intrinsic value (i.e., value conditional on firm insiders’private information) and test hypotheses H5A, H5B, and H8. The risk-shifting hypothesis H5Apredicts no difference in the market valuation of firms issuing putable versus ordinary convertiblesprior to the convertible issue, while the asymmetric information hypothesis H5B predicts thatthe market valuation of putable convertibles issuers prior to the issue will be lower than that ofordinary convertible issuers.

To estimate intrinsic values, we make use of the realized values of the issuers’ sales and bookvalue of equity in the year subsequent to the issue. If firm insiders (managers) have privateinformation regarding their firm’s future cash flows at the time of the issue and have rationalexpectations (so that there is no systematic bias in their prediction of the firm’s future cash flowstream), then the above realized values will yield us an unbiased estimate of the insiders’ valuationof the convertible issuer conditional on their private information at the time of the issue.

To obtain the intrinsic value of the putable or ordinary convertible issuer’s equity, we multiplythe realized values of the issuer’s sales or book value of equity in the fiscal year after theannouncement of the issue by the price-to-sales or price-to-book value ratios, respectively, ofa matched nonissuing firm calculated using sales and book value of equity of this matchednonissuer at the end of the fiscal year preceding the issue and share price on the day prior to theissue announcement.

To ensure the robustness of our results, we select nonissuing matched firms using two differentmatching algorithms. For the first matching algorithm, we follow Purnanandam and Swaminathan(2004) where nonissuing industry peers are selected from the entire Compustat universe aftereliminating the firms that had issued convertible debt in the previous three years, foreign firms,REITs, and closed-end funds. Then, potential matching nonissuers are grouped into 48 industriesthat are constructed based on various categorizations of four-digit industry codes using theindustry classifications in Fama and French (1997). For each year, we divide each industryportfolio into three portfolios based on sales, and we split each sales portfolio into three portfoliosbased on OIBD sales margin [OIBD (Compustat Item 13)/sales (Item 12)]. This procedure givesus nine portfolios for each industry-year. We insist, however, that there are at least three firms ineach portfolio, and if the number of firms in the industry does not allow us to form nine portfolios,we limit ourselves to 3 × 2, 2 × 2, or even one portfolio. Each convertible issuer is then placed intoan appropriate year-industry-sales-OIBD margin portfolio based on the convertible issuer’s salesand OIBD margin in the fiscal year prior to the issue. Within the portfolio, we select matching


industry peers to be the ones that have the closest sales to the convertible issuers. The secondmatching algorithm that we use is the propensity score matching algorithm described earlier (inSection B).

Thus, the per share intrinsic value V of each convertible issuer using either sales or book valueof equity is calculated as follows:

VSales =Issuer next fiscal year sales ×

(P

S

)Match

Issuer CRSP shares outstanding, (2)

VBook value =Issuer next fiscal year book value of equity ×

(P

B

)Match

Issuer CRSP shares outstanding, (3)

where(

P

S

)Match

= Match preannouncement date price × Match CRSP shares outstanding

Match prior fiscal year sales, (4)

(P

B

)Match

= Match preannouncement date price × Match CRSP shares outstanding

Match prior fiscal year book value of equity. (5)

The preannouncement date price-to-intrinsic value ratio for each putable and ordinary convert-ible issuer (P/V ) is calculated as follows by dividing the issuer preannouncement date price bythe per share intrinsic value V calculated above

(P

V

)Sales

= Issuer preannouncement date price

VSales, (6)

(P

V

)Book value

= Issuer preannouncement date price

VBook value. (7)

In the above, preannouncement date price is the share price and CRSP shares outstanding isthe number of shares outstanding of convertible issuers and respective matched nonissuers on theday prior to the announcement of convertible issues as reported by CRSP.

Panel A of Table VII reports the median P/V ratios of putable and ordinary convertible issuers.As expected, ordinary convertible issuers are overvalued as compared to their industry peersaccording to both matching algorithms. The median ordinary convertible issuer is overvaluedrelative to its matched nonissuing industry peer by 12%-18% using the (P/V )Sales multiple andby 6%-11% using the (P/V )Book value multiple. Alternatively, putable convertible issuers are eithercorrectly priced (the median (P/V )Sales ratio of putable convertible issuers is more than one onlyby 1%-2%) or undervalued (the median (P/V )Book value ratio of putable convertible issuers is lessthan one by 4%-8%). Clearly, putable convertible issuers have lower valuations when comparedto ordinary convertible issuers based on both price multiples (the z-statistics testing the equality


Tab

leV

II.

Eq

uit

yV

alu

ati

on

of

Pu

tab

lean

dO

rdin

ary

Co

nvert

ible

Issu

ers

Thi

sta

ble

repo

rts

the

med

ians

ofpr

ice-

to-i

ntri

nsic

valu

e(P

/V)

rati

osof

puta

ble

conv

erti

ble

issu

ers

(als

osp

liti

nto

two

subs

ampl

esof

puta

ble

conv

erti

ble

issu

ers

wit

hab

ove

and

belo

wm

edia

nco

nver

sion

prem

ium

s)an

dor

dina

ryco

nver

tibl

eis

suer

son

eda

ypr

ior

toth

eis

sue

anno

unce

men

tda

y.T

hein

trin

sic

valu

eof

conv

erti

ble

issu

eris

com

pute

dby

mul

tipl

ying

the

real

ized

valu

esof

the

issu

er’s

sale

sor

book

valu

eof

equi

tyin

the

fisc

alye

araf

tert

heis

sue

byth

epr

ice-

to-s

ales

orpr

ice-

to-b

ook

valu

era

tios

,res

pect

ivel

y,of

anin

dust

rype

erca

lcul

ated

atth

een

dof

the

fisc

alye

arpr

ior

toth

eis

sue.

Sal

esar

eth

eto

tals

ales

(Com

pust

atIt

em12

)an

dbo

okva

lue

isth

ebo

okva

lue

ofeq

uity

(Ite

m60

).In

dust

rype

ers

are

sele

cted

:1)

foll

owin

gth

eP

urna

nand

aman

dS

wam

inat

han

(200

4)al

gori

thm

asco

mpa

rabl

epu

blic

lytr

aded

firm

sin

the

sam

eFa

ma

and

Fren

ch(1

997)

indu

stry

asco

nver

tibl

eis

suer

sth

atha

veth

ecl

oses

tsal

esan

dO

IBD

mar

gin

(OIB

D/s

ales

)in

the

fisc

alye

arpr

ior

toth

eis

sue,

and

2)as

com

para

ble

publ

icly

trad

edfi

rms

inth

esa

me

two-

digi

tS

ICco

dein

dust

ryas

conv

erti

ble

issu

ers

that

have

the

clos

est

prop

ensi

tysc

ore

valu

eba

sed

onth

epr

evio

usfi

scal

year

’s(O

IBD

+in

tere

stin

com

e)/a

sset

s,pr

ofit

mar

gin,

RO

A,

(OIB

D+

inte

rest

inco

me)

/sal

es,

(cap

ital

expe

ndit

ures

+R

&D

)/as

sets

,mar

ket-

to-b

ook,

and

tota

lass

ets.

Pro

pens

ity

scor

elo

gitf

unct

ions

are

esti

mat

edse

para

tely

for

puta

ble

conv

erti

ble

issu

ers

and

ordi

nary

conv

erti

ble

issu

ers

inea

chye

ar.C

onve

rsio

npr

emiu

mis

the

perc

enta

gedi

ffer

ence

betw

een

the

issu

er’s

stoc

kpr

ice

atw

hich

the

conv

ersi

onop

tion

beco

mes

inth

em

oney

and

the

issu

er’s

stoc

kpr

ice

atth

eti

me

ofco

nver

tibl

eis

sue.

z-st

atis

tics

corr

espo

ndto

the

Wil

coxo

ntw

o-sa

mpl

era

nk-s

umte

stte

stin

gth

eeq

uali

tyof

dist

ribu

tion

ofP

/Vra

tios

for

two

subs

ampl

esof

conv

erti

ble

issu

ers.

Ind

us

try

Pe

ers

Se

lec

ted

Fo

llo

win

gth

eIn

du

str

yP

ee

rsS

ele

cte

dU

sin

gth

e

Pu

rna

na

nd

am

an

dS

wa

min

ath

an

(20

04

)P

rop

en

sit

yS

co

reM

atc

hin

gA

lgo

rith

m

Ma

tch

ing

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ori

thm

P/V

Ra

tio

Ba

se

do

nP

/VR

ati

oB

as

ed

on

P/V

Ra

tio

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se

do

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ati

oB

as

ed

on

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ce

/Sa

les

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ltip

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ale

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ult

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ce

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ltip

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mb

er

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um

be

rM

ed

ian

Nu

mb

er

Me

dia

nN

um

be

rM

ed

ian

of

Fir

ms

P/V

of

Fir

ms

P/V

of

Fir

ms

P/V

of

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ms

P/V

Pane

lA.P

rice

-to-

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insi

cVa

lue

Rat

ios

ofP

utab

lean

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rdin

ary

Con

vert

ible

Issu

ers

Put

able

conv

erti

ble

issu

ers

320

1.01

292

0.92

291

1.02

265

0.96

Ord

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yco

nver

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eis

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s1,

181

1.12

1,06

41.

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040

1.18

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1.11

z-st

atis

tic

for

valu

atio

ndi

ffer

ence

−0.7

4−2

.81∗∗

∗−1

.41

−1.9

0∗

Pane

lB.P

rice

-to-

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insi

cVa

lue

Rat

ios

ofP

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leC

onve

rtib

leIs

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sw

ith

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ve-

and

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ow-M

edia

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rsio

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rem

ium

Put

able

conv

erti

ble

issu

ers

wit

hab

ove-

med

ian

conv

ersi

onpr

emiu

m14

81.

0513

30.

9513

60.

9412

20.

92

Put

able

conv

erti

ble

issu

ers

wit

hbe

low

-med

ian

conv

ersi

onpr

emiu

m14

41.

0013

50.

9213

01.

1112

11.

10

z-st

atis

tic

for

valu

atio

ndi

ffer

ence

0.93

−0.2

4−0

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−1.7

2∗

(Con

tinu

ed)


Tab

leV

II.

Eq

uit

yV

alu

ati

on

of

Pu

tab

lean

dO

rdin

ary

Co

nvert

ible

Issu

ers

(Co

nti

nu

ed)

Ind

us

try

Pe

ers

Se

lec

ted

Fo

llo

win

gth

eIn

du

str

yP

ee

rsS

ele

cte

dU

sin

gth

e

Pu

rna

na

nd

am

an

dS

wa

min

ath

an

(20

04

)P

rop

en

sit

yS

co

reM

atc

hin

gA

lgo

rith

m

Ma

tch

ing

Alg

ori

thm

P/V

Ra

tio

Ba

se

do

nP

/VR

ati

oB

as

ed

on

P/V

Ra

tio

Ba

se

do

nP

/VR

ati

oB

as

ed

on

Pri

ce

/Sa

les

Mu

ltip

leP

ric

e/B

oo

kV

alu

eP

ric

e/S

ale

sM

ult

iple

Pri

ce

/Bo

ok

Va

lue

Mu

ltip

leM

ult

iple

Nu

mb

er

Me

dia

nN

um

be

rM

ed

ian

Nu

mb

er

Me

dia

nN

um

be

rM

ed

ian

of

Fir

ms

P/V

of

Fir

ms

P/V

of

Fir

ms

P/V

of

Fir

ms

P/V

Pane

lC.P

rice

-to-

Intr

insi

cVa

lue

Rat

ios

ofP

utab

leC

onve

rtib

leIs

suer

sw

ith

Abo

ve-M

edia

nC

onve

rsio

nP

rem

ium

and

Ord

inar

yC

onve

rtib

leIs

suer

s

Put

able

conv

erti

ble

issu

ers

wit

hab

ove-

med

ian

conv

ersi

onpr

emiu

m14

81.

0513

30.

9513

60.

9412

20.

92

Ord

inar

yco

nver

tibl

eis

suer

s1,

181

1.12

1,06

41.

061,

040

1.18

947

1.11

z-st

atis

tic

for

valu

atio

ndi

ffer

ence

0.10

−2.0

6∗∗−1

.49

−2.1

1∗∗

Pane

lD.P

rice

-to-

Intr

insi

cVa

lue

Rat

ios

ofP

utab

leC

onve

rtib

leIs

suer

sw

ith

Bel

ow-M

edia

nC

onve

rsio

nP

rem

ium

and

Ord

inar

yC

onve

rtib

leIs

suer

s

Put

able

conv

erti

ble

issu

ers

wit

hbe

low

-med

ian

conv

ersi

onpr

emiu

m14

41.

0013

50.

9213

01.

1112

11.

10

Ord

inar

yco

nver

tibl

eis

suer

s1,

181

1.12

1,06

41.

061,

040

1.18

947

1.11

z-st

atis

tic

for

valu

atio

ndi

ffer

ence

−1.0

8−1

.60

−0.8

6−0

.13

∗∗∗ S

igni

fica

ntat

the

0.01

leve

l.∗∗

Sig

nifi

cant

atth

e0.

05le

vel.

∗ Sig

nifi

cant

atth

e0.

10le

vel.


of distributions of P/V ratios for putable and ordinary convertible issuers are negative for bothprice multiples and are statistically significant for (P/V )Book value ratios). For example, the medianP/V ratios for putable convertible issuers based on book value are 0.92 and 0.96 depending onthe matching algorithm used, while the same median ratios for ordinary convertible issuers are1.06 and 1.11, respectively. These differences are significant at the 1% and 10% levels. Thus, theresults of our valuation analysis provide some support for the asymmetric information hypothesisH5B and are inconsistent with the risk-shifting hypothesis H5A.

Next we test the asymmetric information hypothesis H8, which predicts that the average marketvaluation of firms issuing putable convertibles with a high conversion premium prior to the issuewill be lower than that of firms issuing putable convertibles with a low conversion premium. PanelB of Table VII indicates that the median P/V ratios based on the Purnanandam and Swaminathan(2004) matching algorithm of firms issuing putable convertibles with above median conversionpremium are slightly larger than those of firms issuing putable convertibles with below medianconversion premium. These differences are not statistically significant. However, the median P/Vratios based on the propensity score matching algorithm of firms issuing putable convertibles withabove median conversion premium are smaller than those of firms issuing putable convertibleswith below median conversion premium. The difference in the median (P/V )Book value ratiosbetween the two groups is significant at the 10% level.

Further, Panel C of Table VII demonstrates that the median P/V ratios of firms issuing putableconvertibles with above median conversion premium are smaller than those of ordinary convert-ible issuers. The differences in the median (P/V )Book value ratios between these two groups aresignificant at the 5% level based on both matching algorithms. Panel D of Table VII reportsthat although the median P/V ratios of firms issuing putable convertibles with below medianconversion premium are smaller than those of ordinary convertible issuers, the differences insuch ratios are not statistically significant.

Thus, our results in Panels B, C, and D of Table VII provide an indication that firms issuingputable convertibles with above median conversion premium are somewhat more undervalued ascompared to firms issuing putable convertibles with below median conversion premium. Theseresults are broadly consistent with the asymmetric information hypothesis H8.

E. The Long-Run Stock Return Performance of Putable and Ordinary

Convertible Issuers

In this section, we examine the long-run stock return performance of putable and ordinaryconvertible issuers and test the asymmetric information hypothesis H10. This hypothesis predictsthat putable convertible issuers will have better long-run stock return performance than ordinaryconvertible issuers.

We study the long-run stock return performance by creating calendar-time portfolios of con-vertible issuer returns using the Fama and French (1993) three-factor model. This multifactormodel serves as a benchmark for expected returns. In this approach, the estimates of interceptsserve as measures of monthly abnormal returns with negative intercepts indicating underperfor-mance and positive intercepts indicating overperformance. We estimate the following regressionincluding the entire sample of putable and ordinary convertible issuers

(Rpt − R f t ) = α + γ Putable dummy + β1(Rmt − R f t ) + β2(Rmt − R f t )Putable dummy

+ s1 SMBt + s2 SMBt Putable dummy + h1 HMLt + h2 HMLt Putable dummy + εt ,

(8)


where the dependent variable for each calendar month t of the estimation period is the averagemonthly percentage return on a portfolio of convertible issuers that have issued convertible debtduring the prior 60 months (Rpt) minus the one-month T-bill yield in month t (Rft). Rmt is the returnon the CRSP value-weighted index in month t, SMBt is the return on a portfolio of small stocksminus the return on a portfolio of large stocks in month t, and HMLt is the return on a portfolioof high book-to-market stocks minus the return on a portfolio of low book-to-market stocksin month t. We test the differences in the long-run performance between putable and ordinaryconvertible issuers by including in Equation (8) a dummy variable equal to one for putableconvertible issuers, and zero for ordinary convertible issuers (Putable dummy) and interacting itwith the three Fama and French (1993) factors. Thus, the estimate of α in Equation (8) representsthe monthly abnormal returns of ordinary convertible issuers and the estimate of γ representsthe difference between the monthly abnormal returns of putable convertible issuers over those ofordinary convertible issuers. The estimate of γ is expected to be positive if putable convertibleissuers have better long-run stock return performance as compared to ordinary convertible issuers.

Table VIII presents the results of our estimations of Equation (8) using OLS and WLS re-gressions for equally and value-weighted portfolio returns.31 The estimates of α are all negativeand significant indicating that ordinary convertible issuers realize significantly negative monthlyabnormal returns in the five-year period after the issue (ranging from −0.25% to −0.81%). Thecoefficient estimates of Putable dummy (γ ) are all positive and, compared to the estimates ofα, are smaller in absolute terms. This indicates that although putable convertible issuers alsorealize negative abnormal returns in the five-year period after the issue (ranging from −0.11%to −0.33%), such returns are less negative than those of ordinary convertible issuers. The coef-ficient estimate of Putable dummy (γ ) is positive and statistically significant at the 5% level inour OLS regression with equally weighted portfolio returns indicating that putable convertibleissuers significantly overperform ordinary convertible issuers (the monthly abnormal return ofordinary convertible issuers is −0.81% and it is −0.33% for putable convertible issuers). Theseresults are consistent with the asymmetric information hypothesis H10.32

F. The Choice between Putable and Ordinary Convertible Issues

In this section, we investigate the choice between putable and ordinary convertibles in amultivariate setting. We run a set of logit regressions with the dependent variable equal to one ifthe convertible issue is putable and zero if it is ordinary. The independent variables relate to ourthree hypotheses: 1) five independent variables relate to the risk-shifting hypothesis (Shumway(2001) bankruptcy measure (SBM), long-term debt over assets, capital expenditures over assets,stock return volatility, and firm size), 2) one independent variable relates to the asymmetricinformation hypothesis (price-to-intrinsic value (P/V ) ratio based on the price-to-book valuemultiple using the Purnanandam and Swaminathan, 2004, matching algorithm), and 3) oneindependent variable relates to the tax savings hypothesis (income tax obligations in the fiscalyear prior to the issue normalized by sales). We use two other independent variables as controlvariables: 1) cash flow/assets is used to control for operating performance prior to the issue and2) the investor sentiment index is used to control for an alternative explanation for the issuance

31For weighted least squares (WLS) the weights are determined by the number of convertible issuers in the monthlyportfolio.32We also conducted a long-run stock return performance analysis of putable and ordinary convertible issuers by comparingtheir postissue holding-period returns to those of two benchmarks, matched nonissuers, and the CRSP value-weightedindex. Our findings using holding period returns were broadly consistent with our results using the Fama-French (1993)three-factor model.


Tab

leV

III.

Po

sti

ssu

eS

tock

Retu

rnP

erf

orm

an

ce

of

Pu

tab

lean

dO

rdin

ary

Co

nvert

ible

Issu

ers

Tim

e-se

ries

regr

essi

ons

ofpo

stis

sue

mon

thly

perc

enta

gere

turn

sof

conv

erti

ble

issu

ers

usin

gth

eFa

ma-

Fren

ch(1

993)

thre

e-fa

ctor

mod

el

(Rpt

−R

ft)=

α+

γP

utab

ledu

mm

y+

β1(R

mt−

Rft)+

β2(R

mt−

Rft)P

utab

ledu

mm

y+

s 1SM

Bt+

s 2SM

Bt

Put

able

dum

my

+h 1

HM

Lt+

h 2H

ML

tP

utab

ledu

mm

y+ε

t,

whe

reR

ptis

the

retu

rnon

the

port

foli

oof

sam

ple

firm

sin

mon

tht;

Rft

isth

eon

e-m

onth

T-bi

llyi

eld

inm

onth

t;P

utab

ledu

mm

yis

adu

mm

yva

riab

leeq

ual

toon

efo

rpu

tabl

eco

nver

tibl

eis

suer

s,an

dze

rofo

ror

dina

ryco

nver

tibl

eis

suer

s;R

mt

isth

ere

turn

onth

eva

lue-

wei

ghte

din

dex

ofN

YS

E,A

ME

X,a

ndN

AS

DA

Qst

ocks

inm

onth

t;SM

Bt

isth

ere

turn

onsm

all

firm

sm

inus

the

retu

rnon

larg

efi

rms

inm

onth

t;an

dH

ML

tis

the

retu

rnon

high

book

-to-

mar

ket

stoc

ksm

inus

the

retu

rnon

low

book

-to-

mar

kets

tock

sin

mon

tht.

The

fact

orde

fini

tion

sar

ede

scri

bed

inFa

ma

etal

.(19

93).

The

sam

ple

peri

odis

Febr

uary

1982

-Dec

embe

r20

08(3

23m

onth

s)an

dsa

mpl

efi

rmre

turn

sar

ein

clud

edin

apa

rtic

ular

mon

thly

port

foli

oif

the

firm

’sco

nver

tibl

ede

btof

feri

ngda

teoc

curr

edw

ithi

nth

ela

st60

mon

ths.

The

num

ber

ofpu

tabl

eco

nver

tibl

eis

suer

sin

the

mon

thly

port

foli

ora

nges

from

1to

234

and

the

num

ber

ofor

dina

ryco

nver

tibl

eis

suer

sin

the

mon

thly

port

foli

ora

nges

from

3to

615.

Reg

ress

ions

(1)

and

(2)

use

equa

llyw

eigh

ted

(EW

)re

turn

s,w

hile

Reg

ress

ions

(3)

and

(4)

use

valu

e-w

eigh

ted

(VW

)re

turn

s(w

ith

valu

em

easu

red

asth

esa

mpl

efi

rm’s

mon

th-e

ndm

arke

tca

pita

liza

tion

inth

em

onth

prio

rto

the

port

foli

ofo

rmat

ion)

.Reg

ress

ions

(1)

and

(3)

are

esti

mat

edus

ing

ordi

nary

leas

tsq

uare

s(O

LS

),an

dR

egre

ssio

ns(2

)an

d(4

)ar

ees

tim

ated

usin

gw

eigh

ted

leas

tsq

uare

s(W

LS

)w

ith

the

wei

ghts

base

don

the

num

ber

ofis

suin

gfi

rms

inth

em

onth

lypo

rtfo

lio.

Para

met

eres

tim

ates

are

pres

ente

dw

ith

t-st

atis

tics

inpa

rent

hese

s.

αγ

β1

β2

s 1s 2

h1

h2

R2

(1)

EW

Port

foli

os/O

LS

−0.8

14∗∗

∗0.

481∗∗

1.30

9∗∗∗

−0.2

37∗∗

∗0.

893∗∗

∗−0

.344

∗∗∗

0.03

10.

071

0.81

(−4.

75)

(1.9

7)(3

1.40

)(−

4.01

)(1

5.86

)(−

4.32

)(0

.48)

(0.7

7)

(2)

EW

Port

foli

os/W

LS

−0.6

27∗∗

∗0.

346

1.26

5∗∗∗

−0.1

160.

885∗∗

∗−0

.382

∗∗∗

−0.0

590.

161

0.86

(−5.

07)

(1.2

2)(4

2.75

)(−

1.55

)(2

1.20

)(−

3.81

)(−

1.19

)(1

.36)

(3)

VW

Port

foli

os/O

LS

−0.2

89∗

0.18

21.

173∗∗

∗−0

.194

∗∗∗

0.34

0∗∗∗

−0.0

99−0

.402

∗∗∗

0.12

70.

78(−

1.65

)(0

.73)

(27.

60)

(−3.

23)

(5.9

2)(−

1.22

)(−

6.06

)(1

.35)

(4)

VW

Port

foli

os/W

LS

−0.2

51∗∗

∗0.

022

1.14

6∗∗∗

−0.1

01∗

0.31

5∗∗∗

−0.2

43∗∗

∗−0

.412

∗∗∗

0.21

9∗∗0.

90(−

2.73

)(0

.10)

(52.

13)

(−1.

81)

(10.

15)

(−3.

26)

(−11

.09)

(2.4

9)

∗∗∗ S

igni

fica

ntat

the

0.01

leve

l.∗∗

Sig

nifi

cant

atth

e0.

05le

vel.

∗ Sig

nifi

cant

atth

e0.

10le

vel.


of putable convertibles suggested by practitioners, namely, the “issuer optimism” hypothesis asdescribed in the next section.

We construct a monthly series of the investor sentiment index after Baker and Wurgler (2006).The greater the value of the index, the more optimistic the investors and vice versa. Since oneof the definitions of investor sentiment that Baker and Wurgler (2006) use in their work is “. . .optimism or pessimism about stocks in general,” this index is a good proxy to measure the degreeof outside investors’ optimism or pessimism regarding future economic activity, the stock marketin general, and the future stock return performance of issuing firms. The index is constructedusing several proxies suggested in the literature to measure investor sentiment. It is a compositeindex based on the first principal component of those proxies. The underlying proxies of investorsentiment are: 1) the closed-end fund discount, 2) NYSE share turnover, 3) the number and averagefirst day returns on IPOs, 4) the equity share in new issues, and 5) the dividend premium. Thesesentiment proxies are measured monthly for the sample period. While the investor sentimentindex we construct is a monthly series as opposed to the annual series constructed by Baker andWurgler (2006), we follow Baker and Wurgler (2006) closely in constructing the above index,making use of monthly data.33 Due to space limitations, we will not describe the details of theabove construction here.34 We have verified that our monthly series closely follows the annualseries of Baker and Wurgler (2006) and has properties similar to their annual series, while havingthe advantage of capturing intrayear variations in investor sentiment (which is clearly not possiblewith an annual series).

We expect all the independent variables related to the risk-shifting hypothesis (except firm size)to have positive coefficients (we expect a negative coefficient for firm size) if putable convertiblesare issued to mitigate potential risk-shifting. We expect the asymmetric information hypothesisvariable to have a negative coefficient since this hypothesis predicts that putable convertibleissuers will have lower market valuation when compared to ordinary convertible issuers. Weexpect the tax savings hypothesis variable to have a positive coefficient if putable convertiblesare issued for tax saving purposes. Finally, we expect the investor sentiment index to have anegative coefficient if, as suggested by the “issuer optimism” hypothesis in the next section,putable convertibles are issued in periods when investors’ outlook regarding future economicactivity and the stock market is more pessimistic. The results of various specifications of ourlogit regressions are presented in Table IX.

The coefficient estimates of the Shumway (2001) bankruptcy measure, capital expendituresover assets, and stock return volatility are all negative while those of firm size are all positive andhighly significant in most specifications. Thus, larger and less risky firms, and those with lowercapital expenditures and with lower bankruptcy probabilities, are more likely to issue putablerather than ordinary convertibles. These findings imply that putable convertible issuers are lesssubject to risk-shifting as compared to ordinary convertible issuers, and, as such, do not providesupport for the risk-shifting hypotheses H1 and H2. Next, the asymmetric information variablehas a negative coefficient estimate in all specifications indicating that relatively undervaluedfirms (or firms that have favorable private information regarding their future performance notreflected in current market valuations) are more likely to issue putable convertibles rather than

33Baker and Wurgler (2006) construct an annual series of the investor sentiment index and use it to test how subsequentstock returns vary with beginning-of-period sentiment. They show that when beginning-of-period investor sentimentis low (investors are pessimistic), subsequent returns are relatively high for small, young, high volatility, unprofitable,nondividend-paying, extreme growth, and distressed stocks. When sentiment is high (investors are optimistic), on theother hand, these categories of stock earn relatively low subsequent returns.34Additional details of the construction of the above index and data sources are available to interested readers from theauthors upon request.


Tab

leIX

.L

og

itR

eg

ressio

ns

Exp

lain

ing

the

Ch

oic

eb

etw

een

Pu

tab

lean

dO

rdin

ary

Co

nvert

ible

Issu

es

The

depe

nden

tvar

iabl

eis

equa

lto

one

ifth

eco

nver

tibl

eis

sue

ispu

tabl

ean

dze

roif

the

conv

erti

ble

issu

eis

ordi

nary

.See

Tabl

eI

for

defi

niti

ons

ofin

depe

nden

tva

riab

les.

P/V

rati

ois

the

pric

e-to

-val

uera

tio,

whe

reva

lue

isth

ein

trin

sic

valu

eof

the

issu

erco

mpu

ted

base

don

the

mar

ket

pric

e-to

-boo

kva

lue

rati

oof

anin

dust

rype

erfo

llow

ing

Pur

nana

ndam

and

Sw

amin

atha

n(2

004)

.Par

amet

eres

tim

ates

are

pres

ente

dw

ith

t-st

atis

tics

inpa

rent

hese

s.

12

34

56

78

91

0

Inte

rcep

t−1

.447

∗∗∗

−0.4

370.

153

0.09

2−0

.558

1.14

0∗∗0.

032

0.29

5−1

.447

∗∗∗

0.87

3∗∗

(−3.

16)

(−1.

58)

(0.3

0)(0

.18)

(−1.

20)

(2.3

5)(0

.07)

(0.5

9)(−

3.16

)(2

.10)

Shu

mw

ayba

nkru

ptcy

mea

sure

0.04

5−0

.056

−0.1

08−0

.134

∗−0

.216

∗∗∗

−0.0

85−0

.116

0.04

5−0

.189

∗∗∗

(0.7

0)(−

0.82

)(−

1.51

)(−

1.93

)(−

3.10

)(−

1.38

)(−

1.63

)(0

.70)

(−3.

06)

Lon

g-te

rmde

bt/t

otal

asse

ts0.

683

0.91

2∗0.

924∗

1.29

2∗∗∗

1.36

7∗∗∗

1.07

5∗∗∗

1.15

7∗∗0.

683

1.12

6∗∗

(1.4

3)(1

.93)

(1.8

8)(2

.66)

(2.7

6)(2

.75)

(2.2

8)(1

.43)

(2.5

1)C

apit

alex

pend

itur

es/t

otal

asse

ts−4

.096

∗∗∗

−2.5

17∗∗

−2.2

69∗∗

−2.6

87∗∗

−3.1

43∗∗

∗−2

.695

∗∗∗

−2.6

16∗∗

−4.0

96∗∗

∗−2

.218

∗∗

(−3.

75)

(−2.

38)

(−2.

14)

(−2.

50)

(−2.

93)

(−2.

72)

(−2.

44)

(−3.

75)

(−2.

19)

Sto

ckre

turn

vola

tili

ty−1

0.07

4∗−2

6.41

6∗∗∗

−26.

548∗∗

∗−2

5.67

1∗∗∗

−26.

285∗∗

∗−2

6.93

6∗∗∗

−25.

688∗∗

∗ −10

.074

∗−3

0.25

0∗∗∗

(−1.

87)

(−4.

35)

(−4.

37)

(−4.

22)

(−4.

47)

(−4.

97)

(−4.

24)

(−1.

87)

(−5.

62)

Mar

ketv

alue

ofeq

uity

0.10

8∗∗∗

0.08

8∗∗∗

0.08

5∗∗∗

0.08

4∗∗∗

0.08

3∗∗0.

084∗∗

∗0.

082∗∗

∗0.

108∗∗

∗0.

079∗∗

∗

(6.4

7)(5

.41)

(5.1

7)(5

.18)

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ordinary convertibles. This finding is consistent with the asymmetric information hypothesisH5B and does not provide support for the risk-shifting hypothesis H5A. Finally, the income taxvariable has a positive coefficient estimate in all specifications, which is consistent with the taxsavings hypothesis H11.

The Investor Sentiment Index has a negative coefficient significant at the 1% level in all spec-ifications suggesting that putable convertibles are more likely to be issued at times when theinvestors’ outlook regarding future economic activity and the stock market is more pessimistic.This supports “issuer optimism” as an alternative explanation for the issuance of putable con-vertibles (see, however, the discussion in the next section). To summarize, the results of our logitregressions are broadly consistent with the asymmetric information and tax savings hypothesesand do not provide any support for the risk-shifting hypothesis.35

IV. An Alternative Explanation

A possible alternative explanation suggested by practitioners for the issuance of putable con-vertibles is that these securities are issued by CFOs who are overly optimistic about the futureprospects of their firm, and who believe that the put option in their convertibles is less likely tobe in the money when compared to outsiders’ beliefs about the same event. This implies thatissuers’ valuation (conditional on their own personal probability distribution) of the put optionembedded in putable convertibles will be lower than the price outsiders are willing to pay for thisput option (based on the outsiders’ own more pessimistic probability distribution of the firm’sfuture stock price), thus creating gains from trade between the two parties.

The above “issuer optimism” hypothesis implies that firms will be more likely to issue putable(rather than ordinary) convertibles during periods when the difference in beliefs between issuersand outsiders is greater (with the issuers being more optimistic than outsiders). While it is difficultto measure differences in beliefs across issuers and outsiders directly, this hypothesis generatesa testable prediction if we make the additional assumption that the beliefs of issuers about theirfirm’s future prospects are less likely to fluctuate over time compared to those of outside investors(Landier and Thesmar, 2009).36 Given this, we get the testable prediction that putable convertiblesare more likely to be issued by firms during periods when outside investors’ outlook about futureeconomic activity and the stock market (and, therefore, the issuing firm’s future stock price) ismore pessimistic (thereby increasing the difference in the extent of optimism between issuersand outsiders). We control for the above argument in our multivariate analysis by including theinvestor sentiment index in our regressions in Table IX.

It is also possible that the issuer optimism hypothesis is the practitioners’ (nonacademic) wayof stating the asymmetric information hypothesis since issuer optimism (and the difference inbeliefs between firm insiders and outsiders) may be a result of firm insiders’ favorable privateinformation. A negative coefficient estimate of the investor sentiment index in Table IX indicatesthat putable convertibles are more likely to be issued when firm insiders are more optimisticabout their firm’s future prospects, which is also consistent with firm insiders having favorableprivate information. Viewed in this way, the statistical significance of the investor sentiment index

35We also estimated the regressions in this section by running cluster regressions where the clusters were determined bytwo-digit SIC industry codes. Our results were unchanged.36Landier and Thesmar (2009) document that insiders (such as entrepreneurs) tend to be much more optimistic thanprofessional investors regarding the future prospects of their firm, do not change their beliefs easily, and tend to believethat financial markets underestimate the future prospects of their firm.


provides some additional support for the asymmetric information hypothesis. In any case, evenafter controlling for the above alternative explanation, our empirical results broadly support theasymmetric information and tax savings hypotheses.

V. Discussion of Results and Conclusion

This paper presents the first empirical analysis of firms’ rationale for issuing putable convert-ibles in the literature. We used a sample of putable and ordinary convertible debt offerings toexplore three possible rationales for issuing putable convertible debt, namely, the risk-shiftinghypothesis, the asymmetric information hypothesis, and the tax savings hypothesis.

Our empirical findings regarding the three possible rationales for issuing putable convertiblesare as follows. First, putable convertible issuers are larger, less risky firms with smaller growthopportunities and a lower overall bankruptcy probability as compared to ordinary convertibleissuers. These results do not support the risk-shifting hypothesis. Second, putable convertibleissuers have lower preissue market valuations when compared to ordinary convertible issuers.Additionally, they also experience less negative abnormal stock returns upon the announcementof an issue when compared to a matched sample of ordinary convertible issuers. Moreover,putable convertible issuers exhibit better long-run postissue operating performance as comparedto ordinary convertible issuers. Also, among putable convertible issuers, the subsample of firmsissuing putable convertibles with larger conversion premia (i.e., with conversion options that aremore out of the money) have lower preissue market valuations, more favorable announcementeffects, and better long-run postissue operating performance than the subsample of firms issuingputable convertibles with smaller conversion premia. The last four results support the predictionsof the asymmetric information hypothesis for issuing putable convertibles. Furthermore, firmsissuing putable convertibles have greater tax obligations than those issuing ordinary convertibles.Additionally, a greater proportion of putable convertible issues fall into higher credit ratingcategories when compared to ordinary convertible issues. These two results provide support forthe tax savings hypothesis. Finally, putable convertible issuers have better long-run postissuestock return performance as compared to ordinary convertible issuers. Overall, the results ofour univariate as well as multivariate analyses of a firm’s choice between putable and ordinaryconvertibles support the asymmetric information and tax savings hypotheses, but do not provideany support for the risk-shifting hypothesis. �

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Documents

What Drives the Issuance of Putable Convertibles: RiskShifting