Catering Convertible Design to Hedge Fund Demand

Abstract

The investor base in the primary convertible bond market experienced a major change towards the end of the 20th century, as convertible bond arbitrageurs entered a market that had been traditionally dominated by long-only investors. We document the impact of this shift in investor type on convertible bond issuer characteristics, design, and pricing. We find that firms taking advantage of the increased demand from convertible bond arbitrageurs were not only financially constrained issuers, but to a larger extent firms with debt capacity available. We also document that the ability of these arbitrageurs to diversify equity risk alters the relationship between convertible bond delta and underpricing. This change allows issuers to accommodate the preferences of hedge funds through a more equity-like bond design, while obtaining better pricing in the process.

Keywords: Capital Supply, Convertible Debt, Hedge Funds