Callable or Convertible Debt? The Role of Debt Overhang and Covenants
56 Pages Posted: 23 Nov 2020 Last revised: 29 Dec 2022
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: Suggested Citation