TO CALL OR NOT TO CALL CONVERTIBLE DEBT

If a firm calls its convertible debt, then the bondholders are forced to choose between receiving cash or equity. Moreover, if the firm call s when the bond's conversion value exceeds its call price, that is, wh en the convertible bond is ''in-the-money,'' rational bondholders shou ld choose the stock. Several financial analysts have argued that-in th e interest of existing stockholders-management should call and force t his conversion into stock as soon as it is feasible to do so, which is as soon as the conversion value exceeds the call price plus accrued i nterest. If management does not force conversion and the firm subseque ntly does well, bondholders will eventually convert to stock anyway. H owever, if the firm does poorly, the bondholders will eventually choos e cash by waiting to maturity. Calling takes away the bondholders' opt ion to take cash at maturity if the firm does poorly and forces them t o share with existing stockholders in any possible decline in value. H owever, numerous studies have found that instead of calling as soon as the bond's conversion value exceeds its call price, calls are typical ly delayed so that (when called) the conversion value of the bond far exceeds its call price. These studies also find that the stock market reacts negatively to the call announcement. Several explanations have been offered for the delay and negative market reaction: 1) management does nor call if the expected dividends to be received by converting bondholders exceed after tax interest payments; 2) firms may refrain f rom calling in order to signal that they foresee the firm doing well; and 3) management delays to ensure there is little chance that convers ion value will fall below the call price during the call notice period . However, these theories have not been tested in a comparative fashio n heretofore. Our study is the first to test several theories by follo wing convertible bond issues over the first ten years of their life an d examining when, if at all, firms call. We confirm the previous findi ng that most firms delay calling until the conversion value exceeds th e call price by a substantial margin but also find that many continue not to call even when conversion value is far above par value. We find that the firms are unlikely to call if either current or expected fut ure dividends to be received after conversion exceed the after-tax int erest payments and are extremely unlikely to call if dividends exceed pre-tax interest. The negative market reaction apparently arises becau se the call reveals that management does not expect that dividends wil l exceed after-tax interest payments in the near future. We find no ev idence that the firms are more likely to call if management foresees b ad times ahead and no evidence that they care about exhausting the bon dholders' option to take the cash.