EXCHANGEABLE DEBT

Exchangeable debt gives the purchaser the option to exchange the debt for stock of a second company, referred to as the ''convert'' firm. Fo r example, in March of 1985, Petrie Stores issued $150 million of exch angeable callable debt, due in 2010. The exchange feature enabled the purchaser of the debt to exchange each $1 000 face value of debt for j ust over 27 shares of Toys ''R'' Us common stock. Petrie Stores owned a minority interest in Toys ''R'' Us and deposited a sufficient number of Toys ''R'' Us common with an escrow agent to guarantee the exchang e option. Exchangeable debt has been offered by firms since the early 1970s and accounted for approximately six percent of all equity-linked debt in the early 1980s. Firms issued 37 exchangeable debentures from 1971 through 1987 (see Exhibit 1). This research investigates the mot ivations for issuing exchangeable debt and the valuation effects to th e issuing and convert firms. The evidence cited in this research indic ates that firms issue exchangeable debt once they decide to divest of a security holding. A significant proportion of firms issuing exchange able debt had previously pursued the ''convert'' firm in a takeover at tempt (see Exhibit 2). Though issuing firms experience no significant valuation effects, convert firms, on average, experience a -1% abnorma l return (see Exhibit 4). Since exchangeable debt is a divestment stra tegy with a potentially informed investor (the issuer) disposing of a block of stock (the convert firm), the negative valuation effect to th e ''convert'' firms is predictable. Nonetheless, the documented price response is less pronounced than the negative price response associate d with secondary distributions or block sales, which are the likely al ternative forms of disposing of the security holding. The less pronoun ced negative price response on the announcement of an exchangeable deb t offering is consistent with the notion that exchangeable debt offers an investor a repurchase guarantee limiting the losses of investors t o the price of the implicit call option (see Appendix C). Unlike secon dary offerings or block sales, exchangeable debt offers an investor th e guarantee of a ''floor'' should the stock price of the convert firm fall subsequent to issue. The guarantee of a floor on losses to invest ors appears to mitigate the information effects of the announcement re lative to the information effects of, for example, secondary offerings . Firms issuing exchangeable debt often cite one of two possible tax m otivations for issuing exchangeable debt. First. the issuing firm is a ble to capitalize on a security holding while delaying the recognition of capital gains. Any accrued capital gains are not taxed until the c onversion feature is exercised. Second, the issuing firm is able to ho ld the convert firm's stock in escrow, collecting tax-preferred divide nd income (due to the corporate dividend tax exclusion) until the conv ersion feature is exercised. The latter tax advantage only applies to holdings purchased prior to October 1984. It is likely that exchangeab le debt was originally conceived to capitalize on specific features of the tax code. However, these tax motivations do not appear to be pote ntial sources of value to firms issuing exchangeable debt for three re asons. First, there is no abnormal price response to the issuing firm on the announcement of an exchangeable debt issue. Second, there is no evidence that the price response of issuing firms is cross-sectionall y related to estimates of the tax benefits associated with issuing exc hangeable debt. Third, the tax motivations are not unique to exchangea ble debt. Capital gains taxation can be avoided by delaying the sale o f the stock. Tax-preferred dividend income can be captured by issuing debt to purchase stock. Finally, this paper documents that the median underwriting cost of issuing exchangeable debt (1.56%) is less than th e median underwriting cost of a secondary offering (4.7%). This eviden ce, in combination with the less pronounced valuation effects relative to secondary offerings or block sales, provides some justification fo r the use of exchangeable debt as a divestment strategy. Aside from th is evidence, I conclude that exchangeable debentures are a neutral mut ation of previously existing divestment strategies and represent an un convincing attempt to capitalize on specific characteristics of the ta x code.