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Disappearing Call Delay and Dividend-Protected Convertible Bonds

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Abstract

Firms do not historically call their convertible bonds as soon as conversion can be forced. A number of explanations for the delay rely on the size of the dividends that bondholders forgo so long as they do not convert. We investigate an important change in convertible security design, namely, dividend protection of convertible bond issues. Dividend protection means that the conversion value of the convertible bond is unaffected by dividend payments and thus dividend-related rationales for call delay become moot. We document that call delay is near zero for dividend-protected convertible bonds. This article is protected by copyright. All rights reserved

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... Today, dividend-protected stock options are widely traded in the overthe-counter (OTC) market. Likewise, most convertible bonds and hybrid securities offer protection against dividends since the late 2000s (see Grundy et al. [2014], Grundy and Verwijmeren [2016]). This popular feature of convertible issuances responds to the need of convertible investors to be protected against dividend-induced wealth transfer from bondholders to stockholders 1 . ...
... This appears to induce a structural bias in protection: the re-striking method no longer boils down to a mere removal of forthcoming dividends from the stock price process, as it is often assumed in option or convertible markets and known as the "zero-dividend" valuation approach. Grundy and Verwijmeren [2016] go as far as suggesting that the zero-dividend approach was at the root of the introduction of dividend-protected convertible bonds: "Since dividend protection immunizes a convertible bond's conversion value against changes in dividend policy, dividends have only a muted effect on the value of a dividend-protected convertible, simplifying valuation." The purpose of this paper is precisely to explore this "muted" effect of dividends. ...
... Similarly, the full dividend protection of convertible bonds can be thought of as inhibiting voluntary conversion by the rational bondholder. However, in contrast with equity options, the analysis needs to be performed at the level of the firm value to take into account the credit risk as well as the problem of dilution (see Grundy and Verwijmeren [2016]). ...
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Altering the terms of a call option to fully protect its value when the underlying stock goes ex-dividend turns out to be trickier than one might think, and the same problem applies to protecting a convertible bond when a stock dividend is paid. Simply lowering the strike price by the same proportion that the stock price falls reduces (S – X) by the same percentage, so to maintain the option's intrinsic value in dollars, the number of options must also be increased. This re-striking method equalizes the option's exercise value before and after the dividend, but the volatility of the underlying still changes. Zimmermann proposes a new correction method that preserves option value when dividends are paid. The difference between valuation under the new method and under the re-striking method is not insignificant, amounting to several points of implied volatility for a holding period of three to five years.
... Those funds buy MCNs at issuance and hedge synthetically the security using the theoretical decomposition into call-spread, prepaid forward and the strip of coupons. The research from Amman and Seiz [13] uses MCNs that mainly didn't include dividend protection clauses since they have been generalized in the convertible market since 2007 as per Grundy and Verwijmeren [14]. Dividend protection clauses adjust the strikes and ratios of the upper call convertibles when the dividends diverge from the contractually agreed path of future dividends at issuance, therefore, any future variation of dividends will be incorporated in the market price of MCNs and the securities are shielded against a change in the dividend policy of the underlying shares. ...
... The convertible market has evolved since the year 2000 and particularly from 2010 onwards since an important proportion of MCNs investors are hedge funds and arbitrage investors. The format of the security has evolved to cater for the appetite of such investors, following Grundy [12,14]. Dividend adjustment clauses have been designed to facilitate convertible arbitrage techniques and most issues now include such clauses. ...
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Debt securities are often an efficient and inexpensive resource to finance the balance sheet of companies; however, one of the causes of the global financial crisis was the excessive leverage taken by companies. Hybrid capital instruments share characteristics of equity and debt, and allow companies to finance its balance sheet in a more sustainable way by reducing leverage, but tend to increase its overall cost of capital. Mandatory convertible notes (MCNs) are hybrid financing instruments that are very close to equity; rating agencies assign them a high equity component and are commonly treated as equity by accounting standards. Despite the high nominal coupon that MCNs seem to pay in some cases, a deeper analysis shows that the cost of issuing MCNs can be similar and even lower than the cost of issuing senior debt. This research performs an empirical study of the implicit cost of the MCNs issued between 2010 and 2018. The study shows the relationship between the implicit yield of MCNs, the senior debt yield, and the convertible arbitrage investors. MCNs can be a sustainable capital alternative that offers a reasonable cost not only for high-yield companies but also for well-established investment grade issuers. The access to efficient and not very expensive capital to finance the balance sheet of companies can promote sustainable growth, industrialization, and innovation.
... For example, while convertible bonds are as liquid as stocks in China, coupon payments from bond also have the same tax rate as stock dividends, so tax consideration in making conversion decisions in the U.S. market (Asquith and Mullins, 1991) is not a concern in the Chinese market. Moreover, all bond covenants contain the dividend protection clause, so firms are anticipated to call back their convertible bonds when criteria are met as argued in Grundy and Verwijmeren (2016). This reduces conversion premium to a level close to or below zero when forced conversion is expected. ...
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We document frequent occurrences of negative conversion premium (NCP) events in the Chinese convertible bond market, when the bond is convertible and the underlying stock can be freely sold. This implies that when an NCP event occurs, existing stock holders can earn a riskless profit through a long-short strategy which sells the underlying stock and buys the convertible bond at the same time, then converts the bond into stocks. Facing short sale constraints, traders not holding any position in the underlying stock can still profit from an overnight trading strategy which buys the convertible bond at the NCP event day t, then sells the converted stock on day t + 1. We also find that the next-day opening prices following NCP events are significantly lower, which is evidence for the stock selling from the overnight trading strategy. Overall, our findings show that investors in China are aware of the NCP events and they earn abnormal returns through active trading. However, it remains as a puzzle why existing stock holders such as institutional investors do not trade away the negative conversion premium through the riskless long-short strategy.
... Most convertible bonds issued after 2002 are dividend-protected, which implies that the underlying shares are immunized from all but a liquidating dividend payment. Grundy and Verwijmeren (2012) show that, unlike their unprotected counterparts ( Ingersoll, 1977), dividend-protected convertibles are called virtually without delay. They argue that part of the popularity of dividend protection clauses can be explained by their accelerating impact on issuers' call incentives. ...
... Most up-to-date convertible bonds are becoming dividend-protected, which makes it hard to find call delay phenomenon. Grundy and Verwijmeren (2016) investigated 471 callable convertibles issued during the period 2000-2008 and found that 60.08% of convertible bond samples were dividend-protected with an increasing trend. They found a close connection between call delay and dividend payout of callable convertible bonds; call delay is near zero for dividend-protected convertible bonds. ...
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University of British Columbia, Vancouver, B.C., Canada. The authors acknowledge the helpful comments of a referee of this journal, Jon Ingersoll, which have led to substantial improvements in the paper.
Article
assumptions than are required for the solution of the convertible pricing function. The optimal call policy can be stated with the following simple rule: A convertible security should be called as soon as its conversion value (i.e., the value of the common stock which would be received in the conversion exchange) rises to equal the prevailing effective callprice (i.e., the stated call price plus accrued interest). This is a strong result since the implementation of the implied strategy requires knowledge of only the call price and conversion terms, both stated contractual items, and the observable market price of the common stock. In testing the convertible pricing model it is logical to start by examining these call policy predictions since they are so straightforward. Furthermore, any deviation from the optimal call policy is likely to cause discrepancies between the model prices and the market prices of convertibles. The thrust of this paper is threefold. First, the observed call policies of convertible-issuing firms will be compared to the optimal call policy. Second, the model's simplifying assumptions will be relaxed in an attempt to explain the deviations. Finally, the pricing model, will be adapted to include the discrepancies. II. THE PRICING OF CONVERTIBLES Before addressing the substantive problems of this paper it is necessary to summarize the results deduced in the earlier paper. Unlike simpler option securities (warrants, calls, and puts) convertible bonds and preferred stocks contain dual options. The bondholder has the right to exchange his convertible for the company's common stock while the company retains the right to call the issue at a contracted call price. Clearly the convertible's value will be affected not only by the conversion strategies and call policy adopted by investors and the firm but also by each party's expectations of the other's actions. To make a problem of this type solvable, it is usually assumed that each party rationally determines its optimal action and expects others to do the same. This is the Miller-Modigliani [11] assumption of "symmetric market rationality."
Article
In this paper we attempt to resolve two puzzles concerning convertible debt calls. The first is that although it has been shown that conversion of these bonds should optimally be forced as soon as this is feasible, actual calls are significantly delayed relative to this prescription. The second is that common stock returns are significantly negative around the announcement of the call of a convertible debt issue. Our purpose is to simultaneously rationalize managers' observed call decisions and the market's reaction to them in a framework in which managers behave optimally given their private information, compensation schemes, and investors' reactions to their call decisions. Moreover, investors' reactions are rational in the sense of Bayes' rule given managers' call policy. In equilibrium, a decision to call is (correctly) perceived by the market as a signal of unfavorable private information. In addition to rationalizing observed call delays and negative stock returns at call announcement, several other testable implications are derived.
  • James A Campbell
  • William Beranek
Campbell, James A., and William Beranek, 1955, Stock price behavior on ex-dividend dates, Journal of Finance 10, 425429.
call will fail to force conversion if the conversion value drops below the call price at the end of the notice period and convertible bondholders tender their bonds for cash. For models and empirical investigations of the safety premium rationale for call delay
call will fail to force conversion if the conversion value drops below the call price at the end of the notice period and convertible bondholders tender their bonds for cash. For models and empirical investigations of the safety premium rationale for call delay, see Ingersoll (1977b), Jaffee and Shleifer (1990), Asquith and Mullins (1991), Asquith (1995), Ederington, Caton, and Campbell (1997), Butler (2002), Altintig and Butler (2005), and King and Mauer (2014).
empirical investigations of this signaling rationale for call delay, see Ofer and Natarajan
empirical investigations of this signaling rationale for call delay, see Ofer and Natarajan (1987), Acharya (1988), Campbell, Ederington and Vankudre (1991), Ederington, Caton, and Campbell (1997), Ederington and Goh (2001), and King and Mauer (2014).
show that call delay is related to future dividends and that call delay by low-dividend firms is a predictor of future dividend growth and voluntary conversion
  • Grundy Constantinides
Constantinides and Grundy (1986) show that call delay is related to future dividends and that call delay by low-dividend firms is a predictor of future dividend growth and voluntary conversion.
) show that firms that do not delay tend to subsequently experience dividend decreases
  • Ederington Campbell
Campbell, Ederington, and Vankudre (1991) show that firms that do not delay tend to subsequently experience dividend decreases.
show that calls are less likely when dividends exceed after-tax coupons. Consistent with this observation
  • Mullins Asquith
Asquith and Mullins (1991) show that calls are less likely when dividends exceed after-tax coupons. Consistent with this observation, Campbell, Ederington, and Vankudre (1991), Asquith (1995), and King and Mauer (2014) report longer average call delays for bonds when dividends exceed after-tax coupons.
document the existence of many sleeping convertible preferred stockholders
  • Eades Dunn
Dunn and Eades (1989) document the existence of many sleeping convertible preferred stockholders.
An article in a practitioner journal
An article in a practitioner journal, Ferreira and Ouzou (2011), attributes the design change to the passage of the JGTRRA and a belief that dividends would increase.
Convertibles and hedge funds as distributors of equity exposure
  • Brown