UNDERSTANDING THE DESIGN OF CONVERTIBLE DEBT

Craig M. Lewis, Richard J. Rogalski and James K. Seward

Journal of Applied Corporate Finance, 1998, vol. 11, issue 1, 45-53

Abstract: There are now two dominant theories of convertible debt held by academic economists. One theory which has been called the “risk‐shifting” hypothesis–effectively views convertibles as an alternative to straight debt. The second–known as the “sig‐nalling” (or “backdoor‐equity”) theory‐treats convertibles as an alternative to ordinary equity. This article attempts to unify (or at least to illustrate the relationship between) these two theories by focusing on the design of the securities. In structuring a convertible, managers and their investment bankers must make a variety of decisions. Besides the coupon rate, face value, issue size, and maturity, managers must also decide the conversion ratio (the number of shares promised per bond) and the amount of call protection afforded investors. Several of these design features have the effect of making a convertible more like a straight debt or a straight equity issue. The hypothesis underlying the authors' recent research is that the issuers of debt‐like convertibles are attempting to address a somewhat different financing challenge than the issuers of convertibles that behave more like equity. Their findings suggest that the primary aim of “debt‐like” convertible issues is to address investors' uncertainty and concerns about risk, whereas the main goal of “equity‐like” convertibles is to minimize the “information costs” associated with raising new equity.

Date: 1998
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