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Signaling with Convertible Debt

Published online by Cambridge University Press:  06 April 2009

Wallace N. Davidson III ,
John L. Glascock  and
Thomas V. Schwarz
Wallace N. Davidson III
Affiliation:
Department of Finance, Southern Illinois University, Carbondale, IL 62901
John L. Glascock
Affiliation:
Department of Finance, Louisiana State University, Baton Rouge, LA 71270.
Thomas V. Schwarz
Affiliation:
Department of Finance, Southern Illinois University, Carbondale, IL 62901
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Abstract

We test whether the conversion price (ratio) is viewed by the stock market as a credible signal of the firm's future earnings prospects (Kim (1990)) and, subsequently, whether convertible debt serves as backdoor equity financing (Stein (1992)). Examining the conversion price in relation to current stock prices and a priori growth expectations produces an average expected time of less than 1.5 years for convertible bonds to be at-the-money. Thus, as Stein suggests, convertibles appear to be a method of drawing equity into a firm's capital structure. We also find that the size of the firm's announcement period abnormal returns is positively related to the expected time for the convertible to become at-the-money. Given these relationships, we conclude that convertible debt issue announcements, on average, send an equity-like signal to the market.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 30 , Issue 3 , September 1995 , pp. 425 - 440
Copyright
Copyright © School of Business Administration, University of Washington 1995

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