Journal Of Financial And Strategic Decisions Volume 8 Number 3 Fall 1995 AN ALTERNATIVE CALL POLICY FOR CONVERTIBLE DEBT - PDF

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Journal Of Financial And Strategic Decisions Volume 8 Number 3 Fall 1995 AN ALTERNATIVE CALL POLICY FOR CONVERTIBLE DEBT Gerald W. Buetow, Jr. * and Stephen G. Buell ** Abstract The results of this study
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Journal Of Financial And Strategic Decisions Volume 8 Number 3 Fall 1995 AN ALTERNATIVE CALL POLICY FOR CONVERTIBLE DEBT Gerald W. Buetow, Jr. * and Stephen G. Buell ** Abstract The results of this study suggest that current convertible bond call policies do not maximize shareholder wealth. We offer an alternative call policy based on intuitive, firm specific characteristics. In addition, a cost effective trading strategy which results in a profit should a failed conversion occur is also formulated. If management is trying to maximize current shareholder wealth, then both the premiums established in executing current call policies and the 20 percent rule-of-thumb premium are too large. Failed conversion costs are roughly four times the cost of the trading strategy developed to avoid them. This is true for all premium levels. Therefore, the optimal call policy as defined in this study is consistent with management s goal of maximizing shareholder wealth. INTRODUCTION Theory suggests that a firm concerned with maximizing the value of its outstanding common stock should call its convertible debt as soon as the conversion value begins to exceed the call price (Ingersoll 1977a and b; Brennan and Schwartz 1977, 1980). However, Brigham (1966), Mikkelson (1981), and Singh et al. (1991) identified many issues of outstanding convertible debt which exhibited a significant premium between conversion value and call price. Ingersoll and Brigham both found that nearly all firms wait too long before calling their convertible bonds. Ingersoll documented a mean premium of 43.9 percent. 1 Brigham did not use empirical testing; instead, he surveyed 21 large firms and found an average premium of 20 percent. Even though there seems to be no empirical or economic justification for it, one can still find reference to this 20 percent premium in the literature (Asquith and Mullins 1991). Most theories that attempt to explain the large premiums cite the existence of a call notice period and potential failed conversion costs. The call notice period, the time between the announcement of a call and its subsequent execution, is typically thirty days. If the price of a firm s common stock drops so that the conversion value falls below the call price by the end of the notice period, the firm must raise the capital necessary to execute the call. The costs associated with this capital acquisition process are known as failed conversion costs. 2 Using the concept of failed conversion costs, Brennan and Schwartz, and Mikkelson predicted the existence of a premium. However, their results did not reinforce the very large premiums found by Brigham and Ingersoll. Theory does not predict premiums large enough to agree with those actually observed. Consequently, in this study we formulate a premium which more accurately accounts for the tradeoff between shareholder value and the likelihood of a failed conversion. Using this premium, we develop a more efficient convertible call policy. While most of these earlier studies have suggested that the existence of a call notice period and potential failed conversion costs are the primary causes of the premium, others have advanced alternative explanations. Using the sequential equilibrium concept of Kreps and Wilson (1982), Harris and Raviv (1985) developed their information signaling hypothesis to explain both the premium and the negative returns at announcement initially found by Mikkelson. 3 According to the information signaling theory, a firm uses its call policy and resulting premium to convey information to the market. Management calls its bonds only if it acquires unfavorable information about the future prospects of the firm. Conversely, uncalled bonds with large premiums convey favorable information. The theory suggests *James Madison University **Lehigh University 27 28 Journal Of Financial And Strategic Decisions that firms which are in the premium region longer (i.e., have larger premiums) should outperform those firms which are in the premium region for a shorter duration (i.e., have smaller premiums). Ofer and Natarajan (1987) empirically verified the information signaling theory; however, Campbell et al. (1991) and Buetow (1993) both suggest otherwise. Dunn and Eades (1989) proposed that management can maximize firm value by anticipating the voluntary conversion actions of investors. If the after-tax interest payments on its convertible debt are lower than the cash dividends on any newly converted stock, a firm should delay forcing conversion as long as investors do not voluntarily convert. If the firm can accurately anticipate the premium needed to coax passive investors 4 into converting, then it can predict when to call the bond. They successfully tested their theory using convertible preferred stock but did not test it for convertible debt. Using the call notice period and the concept of failed conversion costs, Jaffee and Shleifer (1990) developed their financial distress hypothesis to explain the existence of the premium. A firm calls its convertible debt with the intention of forcing conversion. If the conversion value falls below the call price during the 30 day notice period, the firm could be forced to pay more for the bond than it is worth. 5 The firm may also face exorbitant underwriting costs to raise the necessary capital, especially when the cash must be raised in a short period of time. Jaffee and Shleifer argue that the existence of these costs is responsible for the premium. Their theory suggests that the more volatile the price of the stock, the larger the premium and the longer the bond will be kept within the premium region. While they offer no empirical support for their conclusions, Buetow (1993) evaluated the financial distress hypothesis with positive results. To investigate the existence of the premium, Asquith and Mullins (1991) applied a three step filtering criteria to a sample of bonds whose conversion value exceeded their call price. The first criterion simply considered the restrictive covenant of the bond and eliminated all bonds which were call-protected during the period analyzed. The second criterion eliminated those bonds which had a premium of less than 20 percent. The third criterion eliminated those bonds with after-corporate-tax interest costs less than the dividends on any newly converted shares. The results were impressive. Using this filtering rule, they eliminated 89.5 percent of the original sample; of the remaining bonds, 68 percent were subsequently called during the year following the analysis. They concluded that the cash flow incentive on the part of both management and investors is the primary cause for the premium. Brennan and Schwartz (1982) and Constantinides and Grundy (1985) offered several reasons why a firm might delay calling its convertible bonds. These include: (1) the call could adversely affect managerial compensation, (2) the loss of bondholder goodwill could adversely affect future capital needs, (3) some bondholders could decide not to convert into the common stock even though it is optimal to do so; a larger premium would be expected to reduce this behavior. In section II, we discuss the paper s four objectives. In section III, we describe our original sample of 317 convertible bonds and the filtering rule we used to reduce it to a final sample of 53 bonds. In section IV, we present our methodology and in section V, our results. Section VI contains our concluding remarks. OBJECTIVES This section describes the four objectives of the study. The first is to develop a premium that better balances the tradeoff between maximizing shareholder value and minimizing the probability of a failed conversion. While considerable attention has been given to explaining the presence of a premium, there has been no attempt to estimate it as a function of firm-specific characteristics. If a firm waits for a large enough premium to be established so that the probability of a failed conversion is sufficiently low (to be defined), then the optimal call policy can be expressed in terms of probabilities. Our second objective is to develop a cost-effective trading strategy which will eliminate any loss the firm might suffer in the event of a failed conversion. Furthermore, if the strategy is constructed so that the failed conversion costs are covered under a conservative scenario (to be defined), then under any other scenario in which the conversion value falls to or below the call price, the firm will realize a gain over and above the failed conversion costs. Fortunately, we found the cost of the trading strategy to be significantly less than failed conversion costs, and therefore, it is consistent with the firm s objective of maximizing shareholder wealth. However, before the trading strategy can be fully developed, we need to consider general market effects of the call on the price of the stock (Mikkelson 1981). Because the optimal call policy depends on the failed conversion costs faced by the firm, the trading strategy developed to avoid them, and the probability of a failed conversion, it will be different for each firm. The third objective is to evaluate the economic justification of the 20 percent rule-of-thumb premium employed by practitioners and still cited by academicians (Asquith and Mullins, 1991) years after Brigham s 1966 study. Our final objective is to evaluate whether different bond categories, each with unique financial characteristics, reflect different call policies. An Alternative Call Policy For Convertible Debt 29 DATA Our original sample consisted of the 317 convertible bonds that were called between 1985 and 1991, as reported in Moody s Manuals, Moody s Bond Record, Moody s Bond Survey, or Standard and Poor s Bond Guide. 6 We separated the sample into five categories. Table 1 lists the number of bonds (N), the average premium, and the standard deviation (SDEV) for each category. TABLE 1 Summary Statistics For The Six Bond Categories Category N Premium SDEV Initial Sample (All) % 70.09% Final Sample (S) % % Investment Grade (IG) % 98.51% Below Investment Grade (BIG) % 45.96% No Negative ** (NoNeg) % 69.50% Greater than 200 bp Drop (Grtr 2) % 45.20% ** Bonds with a negative premium were eliminated from the original sample prior to calculating the average and standard deviation. Employing a five step filtering rule, we constructed the final sample (S) of 53 bonds which was used to develop our optimal call model. 7 Step 1 eliminated 50 bonds which had a conversion value less than or equal to the call price at the time of the call. Step 2 eliminated 52 bonds which were called due to a significant reduction in market interest rates. We accomplished this by comparing the market rate at issuance to the equivalent market rate for similarly rated bonds at the time of the call. If the market rate at the time of the call was significantly lower than the rate at issuance 8, we assumed that the bond was called for refunding purposes. Step 3 eliminated 141 bonds that were ranked below investment grade (i.e., below BBB by Standard and Poor s or Baa by Moody s), or not rated at all. Because the period being analyzed was a tumultuous time for low quality issues, firms may have called bonds that were rated below investment grade for a number of reasons. 9 Consequently, we excluded all lower rated bonds from the sample. Step 4 eliminated seven bonds that were variable rate issues or convertible into stock of other than the company which issued the debt. Finally, Step 5 eliminated 14 bonds which were not publicly traded at the time of the call. TABLE 2 Summary Of Filtering Procedure Step Number Of Bonds Before Number Of Bonds Eliminated Number Of Bonds After Final Sample 53 Table 2, which shows the filtering rules in the order described above, summarizes the results. It should be noted that the steps of the filtering procedure are not mutually exclusive. Bonds eliminated by Step 1 might also have been 30 Journal Of Financial And Strategic Decisions eliminated by one of the later steps. The filtering process reduces the original sample of 317 bonds down to the final sample of 53. Using the Compustat database, we obtained historical stock prices and dividends for each firm/bond in the final sample, with the first observation being sixty months prior to when a bond was called. Then we tabulated the mean and standard deviation of the monthly prices and returns for each firm/bond. Finally, we approximated the risk free rate of interest using the 90-day Treasury Bill rate found in the Federal Reserve Bulletins. METHODOLOGY Many of the theories discussed in Section I suggest that a firm waits for a premium to develop that is large enough to ensure that a failed conversion will not occur (i.e.; as much as possible, management wants to guarantee conversion). If the price of its stock falls enough so that the conversion value drops below the call price by the end of the notice period, a firm would incur failed conversion costs by having to raise new capital in order to purchase the bonds. The firm wants to force conversion and avoid these failed conversion costs. However, management must attempt to avoid the failed conversion costs while simultaneously maximizing shareholder value. It is not difficult to appreciate the precariousness of this situation - to minimize the probability of the conversion value falling below the call price during the notice period, management must simply establish a sufficiently large premium. However, as the premium increases, the value of existing shares increases at a slower rate than the convertible debt, and management is not maximizing shareholder value. 10 Consequently, the tradeoff is between decreasing the probability of a failed conversion and increasing shareholder value. The very large premiums documented in the previous section strongly suggest that firms are more concerned with the avoidance of the failed conversion costs than with the maximization of shareholder value. By entering into a properly designed trading strategy using put options, management can reduce the risk of having to pay some or all of the failed conversion costs. Within the framework of call policy, the exercise price of the options is the value of the stock when the conversion value of the bond is equal to its call price plus one 11, and the current value of the stock is the price of the stock at the time of the call. In order to implement the trading strategy and purchase the correct number of put options, the firm must know the value of the failed conversion costs. Since these costs are difficult to quantify, we model previous studies and express them as a percentage of the amount of capital raised (Ingersoll 1977b; Singh et al. 1991). Since management has the ability to actually purchase put options, they are not maximizing current shareholder value when they allow the premium to become larger than optimal (to be defined). The cost of the trading strategy is equal to the price of an option times the number necessary to cover the failed conversion costs. For the trading strategy to be an effective alternative, its cost must be significantly less than the failed conversion costs. The trading strategy must also account for any effects the call policy has on existing shares. Specifically, before using the Black-Scholes model, the price of the put option must incorporate the two percent drop in stock price resulting from the announcement of the call (Mikkelson 1981). In addition to planning a trading strategy, management must also estimate the probability of a given premium level falling to zero (or conversion value falling to the call price) during the call notice period. This implies that each premium will have three values associated with it: trading strategy, probability of failed conversion, and cost of the trading strategy. Optimal Call Premium Within the framework of our model, we define the optimal call premium as that premium (or stock price) level which has a 10 percent probability of a failed conversion. The 10 percent probability level is arbitrary but is intended only as a reference for evaluating both the 20 percent premium level and current call policies. The actual optimal probability value will depend on the risk preferences of a firm s management. However, the importance of the optimal premium is not the probability value itself but the concept of using probabilities within the framework of an optimal call policy. Four Premiums We analyze four different stock price (or premium) levels, S 1, S 2, S 3 and S *. They are defined as follows: An Alternative Call Policy For Convertible Debt 31 Equation 1 σ P S 1 =.98 ( S c+ ) 2 Equation 2 S 2 =.98 ( S c+ σ P ) Equation 3 S 3= 1.18 Call Price conversion ratio Equation 4 S * = Price level with Prob(S * S c ) = 10% where σ P, the standard deviation of monthly stock prices, is calculated over the 60 month period prior to the call; S c, the price of the stock when the bond s call price equals its conversion price, is computed using: Equation 5 Call Price Of The Bond S c = Conversion Ratio and the constants, 0.98 and 1.18, account for the negative call announcement effect. 12 Each bond has four premiums corresponding to the stock price levels defined by equations 1 through 4. S 1 and S 2 express the price levels in terms of firm specific characteristics (i.e., standard deviation of monthly stock prices). We use S 1 and S 2 in order to establish reference levels needed to evaluate optimal call policy. The results in Section V indicate that these levels do, indeed, give reasonable probability values. We use S 3, the price level corresponding to a premium of 20 percent, in order to test whether it should continue to be accepted as a valid rule-of-thumb. S *, the price level in equation (4), corresponds to the optimal call policy defined in the previous section. We need this stock price in order to evaluate whether current call policies maximize shareholder value. We calculate the total premium using: 13 Equation 6 Prem = CR ( S i - S c ) where Prem is the amount of the premium above the call price for each bond prior to the call announcement; CR is the conversion ratio; S c is the price of the stock when the conversion value is equal to the call price of the bond (equation 5); the constant preceding S i is an adjustment factor to account for call announcement effects 14 and S i (adjusted for announcement effects) is defined by equations (1) through (4). Probability Values After calculating the premiums, we compute the probabilities of the stock price at the time of the call, S i, falling to S c by the end of the notice period. These probabilities correspond to the aforementioned premiums. By assuming that the price returns are lognormally distributed (Boyle 1977; Dammon and Spatt 1992), and that the logarithm of a lognormally distributed variable is normally distributed, we can calculate the probabilities given the mean monthly return at the time of the call and the standard deviation of monthly returns. For each bond in the final sample, we calculate three probabilities which correspond to the premium levels of equations (1) through (3). In addition, we also calculate the optimal stock price level, S *, for each bond in the sample. The procedure for these calculations is described in Appendix A. 32 Journal Of Financial And Strategic Decisions Trading Strategy The trading strategy is simply an investment made by the firm at the time a bond is called. The profit from the investment is equal to (or greater than) the failed conversion costs in the event that the conversion value falls to (or below) the call price by the end of the call notice period under a conservative scenario (defined in the following section). The trading strategy offers management an alternative means of avoiding failed conversion costs without having to establish an unnecessarily large premium. The tradeoff between maximizing
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