Callable or Convertible Debt? The Role of Debt Overhang and Covenants

56 Pages Posted: 23 Nov 2020 Last revised: 29 Dec 2022

See all articles by Christian Riis Flor

Christian Riis Flor

University of Southern Denmark

Kirstine Boye Petersen

University of Southern Denmark

Alexander Schandlbauer

University of Southern Denmark ; Danish Finance Institute

Date Written: October 12, 2022

Abstract

We analyze what role debt overhang and covenants have in a manager's choice between issuing callable or convertible debt when a firm needs to issue a substantial amount of debt. Callable bonds provide a higher coupon in exchange for a repurchase option. Convertible bonds offer bondholders the option to exchange debt to equity. Using a dynamic capital structure model with investment choice, we find that callable debt implies a larger debt overhang friction, and for highly leveraged firms convertible debt is preferred. Moreover, if outstanding bonds have net-worth covenants attached, callable bonds are more likely to be issued. Our empirical findings support the theory.

Keywords: Bond characteristics, dynamic model, growth option, debt overhang, covenants

JEL Classification: G31, G32, D81

Suggested Citation

Flor, Christian Riis and Petersen, Kirstine Boye and Schandlbauer, Alexander, Callable or Convertible Debt? The Role of Debt Overhang and Covenants (October 12, 2022). Journal of Corporate Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3512488 or http://dx.doi.org/10.2139/ssrn.3512488

Christian Riis Flor (Contact Author)

University of Southern Denmark ( email )

Campusvej 55
Odense DK-5230
Denmark
+45 6550 3384 (Phone)
+45 6593 0726 (Fax)

HOME PAGE: http://sites.google.com/site/florfinance/Home

Kirstine Boye Petersen

University of Southern Denmark ( email )

Campusvej 55
DK-5230 Odense, 5000
Denmark

Alexander Schandlbauer

University of Southern Denmark ( email )

Campusvej 55
5230
Denmark

HOME PAGE: http://sites.google.com/site/alexanderschandlbauer/

Danish Finance Institute ( email )

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