A note on systematic risk changes around convertible debt issues

Abstract

The analysis of the risk characteristics of an issuing firm provides a further test of the rationing-hypothesis for convertible debt issuance. If investors gradually learn about changes in an issuer’s systematic risk as they apparently do about a firm’s post-issue earnings, this learning process may influence the convertible debt issue decision: it is possible that risk- averse investors deny an issuer the direct access to equity capital, if they have difficulties in evaluating the risk characteristics of an issuing firm or if they anticipate a future increase in systematic risk that may not be compensated with an adequate increase in returns. In these situations, a firm may use convertible debt to enable investors to screen it before the bond can be converted into common stock. During this screening period, uncertainty about the firm’s risk (and earnings) may decrease. The advantage of convertible debt is that its value is relatively insensitive to the risk of the issuing firm, which protects investors from adverse consequences of risk 71