Japanese convertible bond market

Abstract

Convertible bonds are hybrid securities which combine straight debt with an option to convert the debt into equity at maturity or before that depending on the type of bond. The reason that is mostly quoted in the market for issuing these securities is two-fold: • Interest rates on convertible bonds are lower than that on straight debt: there are many problems like asset-substitution and underinvestment as far as straight debt is concerned. Agency theory suggests that managers of a firm in financial distress, try to maximize the returns to the existing share holders of the firm at the cost of lenders by investing in risky projects or not investing in projects with small positive NPVs. Convertible bonds ensure the lenders that they will be a part of any gains in equity due to such activity. Hence convertible bond holders are satisfied by an interest rate lesser than that on straight bonds. • Convertible bonds serve as an opportunity to issue equity at a premium. When a firm is doing very well, managers might feel that their equity is under-priced and he would not want to issue more equity at the lower prevailing price. On the other hand, if managers feel that their stock is trading at a premium to what their expectations are, they would want to lock the gain by issuing more equity. Hence, if a firm raises equity, the market feels that actually the stock is overpriced and they reduce their valuation of the equity of the firm and the stock prices tumble. Thus, when a firm is doing well, with convertible bond issuance there is less information asymmetry compared to issuance of equity and hence the stock prices are not affected negatively1. The firm can set a conversion price and have the convertible bond serve as a route to issue “back-door” equity without a large drop in the stock price. Although the above reasons make sense separately, both cannot be the reason as the first reason for issuance of convertibles is when a firm is in financial distress while the second reason is more applicable when the firm is doing well and managers feel the stock is undervalued. The above arguments are flawed when considered in isolation since when in financial distress; the firm would have been better off issuing equity, with no burden of debt, compared to convertible bonds. In the situation when the firm is doing well, it would have been better off issuing straight debt, which has absolutely no dilution effect, compared to convertible bonds. Presently, two schools of thought exist with regards to the convertible bonds, considering the securities as more “debt like” or “backdoor equity” based on the parameters in its issuance2