Exchangeable Debt

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When Do Firms Issue Exchangeable Debt?

Anna N. Danielova BU 370, Finance Department Kelley School of Business Indiana University 1309 E. 10th St Bloomington, IN 47405 Phone: 812-855-0102, Fax: 812-855-5875 E-mail: adanielo@indiana.edu

This version: August, 2003

Acknowledgements

I would like to thank John Boquist, Robert Jennings, Richard Rosen, Charles Trzcinka, Greg Udell, Andrey Ukhov, and Xiaoyun Yu for their comments and suggestions. A special gratitude goes to Scott Smart for his ongoing support and helpful insights. All errors are mine.

When Do Firms Issue Exchangeable Debt?

Abstract A firm that issues exchangeable debt gives the bondholders the option to exchange their bonds for shares of the underlying firm in which the issuing firm has a stake. We contend that firms time exchangeable debt offerings to profit from the information disparity between themselves and outside investors regarding the prospects of the underlying firm. We conjecture that exchangeable debt is a more attractive market timing device than the direct sale of stock because exchangeable debt defers the capital gains tax and some types of exchangeable debt structures facilitate flexible disposal of the underlying shares. Consistent with the market-timing hypothesis, we find that companies tend to raise more cash with exchangeable debt soon after the underlying stock has appreciated, and, on average, the pre-issue run-up in the underlying asset is reversed after the issue. Moreover, an exchangeable debt issue signals the prospective open market sale of the underlying shares by the issuer. The evidence also suggests that different exchangeable debt payoff structures reflect different degrees of unfavorable information that issuers have about the underlying companies.

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I. Introduction Exchangeable debt, bonds issued by one company which are convertible into common shares of a second company, is a growing phenomenon. Exchangeables accounted for approximately six percent...