Abstract

This paper examines the ability of the risk-shifting hypothesis and the backdoor equity hypothesis to explain firms ’ decisions to issue convertible debt. Using a security choice model that incorporates pre-offer issue, issuer, and macroeconomic information, we document significant variation in the market reaction to new convertible debt issues depending on whether investors expect the motivation for issuance to be asset substitution or asymmetric information. Our results suggest that both motives explain the use and design of convertible debt. Some firms issue convertible debt instead of straight debt to mitigate the costs of bondholder/stockholder agency conflicts. Other issuers use convertible debt instead of common equity to reduce the costs of adverse selection. Thus, in contrast to standard securities like straight debt or common equity, which solve some financing problems but exacerbate others, hybrid securities such as convertible debt are seen as providing a more flexible funding choice that can solve conflicting financing problems. Financial economists study the security issue decision to understand more fully why firms choose to issue a particular security and how investors in financial markets react to that choice. The research documents several results about investor reaction to the announcement of

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