Signaling with Convertible Debt

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.