The role of convertible bonds in alleviating contracting costs

Theoretical research argues that convertible bonds mitigate the contracting costs of moral hazard, adverse selection, and financial distress. Using firm-specific and macroeconomic factors of the contracting costs, we examine the extent to which they impact the likelihood of issuance and the structure of convertible bonds. Our evidence indicates that moral hazard, adverse selection, and expected financial distress costs are all important determinants of the likelihood of issuing convertible bonds over straight bonds. We also analyze the structure of convertible bonds issued by studying whether these bonds are more debt-like or equity-like. The evidence indicates that moral hazard costs do not influence bond structure, while adverse selection costs are somewhat important in determining the structure. Expected financial distress costs have the strongest statistical and economic impact on convertible bond structure. (C) 2007 Board of Trustees of the University of Illinois. Published by Elsevier B.V. All rights reserved.