Why firms issue convertible debt — Market timing and investor rationing

Available theories for the use of convertible debt emphasize the security’s useful role in mitigating costs of external debt and equity finance that arise due to capital market imperfections. Green (1984) argues that convertible debt eliminates risk-shifting incentives and aligns the interests of stock- and bondholders.4. Stein (1992) shows that firms with valuable investment opportunities can use convertible debt to reduce the costs of adverse selection arising in equity issues41, and Mayers (1998) illustrates that convertible debt can alleviate costs of free cash flow.42 Empirical tests of the short-term valuation impact of convertible debt offerings support the implications of these theories: convertible debt issues on average entail higher announcement returns than equity issues.43