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2015 | OriginalPaper | Chapter

5. Motivations for Issuing Putable Debt: An Empirical Analysis

Authors : Ivan E. Brick, Oded Palmon, Dilip K. Patro

Published in: Handbook of Financial Econometrics and Statistics

Publisher: Springer New York

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Abstract

This paper examines the motivations for issuing putable bonds in which the embedded put option is not contingent upon a company-related event. We find that the market favorably views the issue announcement of these bonds that we refer to as bonds with European put options or European putable bonds. This response is in contrast to the response documented by the literature to other bond issues (straight, convertible, and most studies examining poison puts) and to the response documented in the current paper to the issue announcements of poison put bonds. Our results suggest that the market views issuing European putable bonds as helping mitigate security mispricing. Our study is an application of important statistical methods in corporate finance, namely, event studies and the use of general method of moments for cross-sectional regressions.

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See for example, Crabbe (1991), Bae et al. (1994, 1997), Cook and Easterwood (1994), and Roth and McDonald (1999), Nash et al. (2003). Billett et al. (2007) find that 5 % of corporate bonds of their sample have a non-poison putable option.

Other benefits posited by the literature include minimizing tax liabilities. See for example, Brick and Wallingford (1985), and Brick and Palmon (1993).

Brennan and Schwartz (1988) offer a similar argument to explain the benefits of issuing convertible bonds.

See, for example, Modigliani and Miller (1963), Scott (1976) and Kim (1978). In contrast, Miller (1977) suggests that the tax benefit of interest is marginal. However, Mackie-Mason (1990) empirically demonstrates the significant impact of corporate taxes upon the observed finance choices of firms.

Hence, empirically, we would expect that as firms announce increased levels of debt, the stock price should increase. However, studies by Dann and Mikkelson (1984), Mikkelson and Partch (1986), Eckbo (1986), and Shyam-Sunder (1991) indicate that there is no systematic relationship between the announcement of firm’s debt financing and its stock price or that this relationship is weakly negative. One potential explanation for this result is that the market can predict future debt offerings as argued by Hansen and Chaplinsky (1993). Another potential explanation, as suggested by Miller and Rock (1985) and documented by Hansen and Crutchley (1990), is that raising external capital may indicate a cash shortfall.

Myers (1977) demonstrates that shareholders may avoid some profitable net present value projects because the benefits accrue to the bondholders. Jensen and Meckling (1976) demonstrate that leverage increases the incentives for managers, acting as agents of the stockholders, to increase the risk of the firm.

We assume that managers of companies that are overvalued have no incentive to resolve security mispricing. Consequently, managers of undervalued firms could send a credible signal to the market of the firm’s undervaluation with the inclusion of a put feature. Overvalued firms should not be able to mimic since the put option represents a potential liability that is greater to these firms than of the undervalued firms.

The bondholders-stockholders agency conflict has been found to be important in security design by Bodie and Taggart (1978), Barnea et al. (1980), Haugen and Senbet (1981), Jung et al. (1996), and Lewis et al. (1998).

Equivalently, the inclusion of a put option should restrain management from consuming a suboptimal amount of perquisites or nonpecuniary benefits.

Although bonds become due following formal default, hence all bonds in a sense become putable, bondholders usually recover substantially less than face value following formal default because equity value has already vanished. In contrast, a formal inclusion of put option may allow bondholders to recover the face value at the expense of shareholders when financial distress is not imminent but credit deterioration has occurred.

Other studies that have examined managerial myopia include Stein (1988), Meulbroek et al. (1990), Spiegel and Wilkie (1996), and Wahal and McConnell (2000).

Haugen and Senbet (1978, 1988) theoretically demonstrate that the organizational costs of bankruptcy are economically insignificant. However, if the putable bonds increase the potential of technical insolvency, then it will increase potential agency costs that are not necessarily insignificant.

Four bonds have multiple put exercise dates.

Unlike the European put bond sample which we were able to obtain from Warga’s Fixed Income Database, we obtained our sample of poison puts from Dow Jones Interactive by using keywords such as poison put, event risk, and covenant ranking. Warga’s database does not include an identifiable sample of poison put bonds.

We were only able to find a sample of poison put bonds with issue announcements using Dow Jones Interactive and LexisNexis for the period between 1986 until 1991. We did use these news services for the periods between 1979 and 2000.

The event study methodology was pioneered by Fama et al. (1969).

Note that FCF1 is the actual free cash flow of the firm while FCF2 is the (maximum) potential free cash flow if dividends are not paid. We do not subtract capital expenditures from the free cash flow variables because they maybe discretionary and maybe allocated suboptimally to satisfy management’s interests.

Had we assigned the value of 1 to only junk bonds, the number of observations with the risk variable equal to one would be too small for statistical inference.

An alternative measure of the degree of asymmetric information is the number of analysts. The empirical results are robust to this alternative measure.

In the next section, we report the regression results when we exclude financial service companies from our European put sample. Essentially, the basic results of our paper are not affected by the inclusion or exclusion of financial services company.

The violation of the homoscedastic assumption for OLS does not lead to biased regression coefficients estimators but potentially biases the computed t-statistic. The GMM procedure provides an asymptotically unbiased estimation of the t-statistics without specifying the heteroscedastic structure of the regression equation. The t-statistics obtained using GMM are identical to those obtained using ordinary least squares (OLS) in the absence of heteroscedasticity.

If a major motivation for issuing putable bonds is to enhance management entrenchment, then we expect that the value of entrenchment is directly related to the level of free cash flow which management can misappropriate.

Crabbe (1991) demonstrates that bonds with poison puts reduce the cost of borrowing for firms.

Recall that by definition the option of poison put bonds does not have an expiration date.

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Title: Motivations for Issuing Putable Debt: An Empirical Analysis
Authors: Ivan E. Brick
Oded Palmon
Dilip K. Patro
Publisher: Springer New York
Book: Handbook of Financial Econometrics and Statistics
Print ISBN: 978-1-4614-7749-5

Electronic ISBN: 978-1-4614-7750-1

Copyright Year: 2015
DOI: https://doi.org/10.1007/978-1-4614-7750-1_5