Recently, the issuances of equity-linked debt have shown explosive growth in Korea. The issuance of equity-linked debt, which hit a low of 1.7 trillion won in 2014, more than tripled over the next 4 years, reaching about 5.5 trillion won in 2018 (see endnote 1 in Appendix B
). Behind this growth lies the inherent nature of equity-linked debt. Equity-linked debt such as convertible bond (hereafter referred to as CB) and bond with warrant (hereafter referred to as BW) are considered as hybrid securities that form an intermediate class of securities between equity and debt [1
]. This distinctive characteristic of equity-linked debt provides several benefits to issuers. First, the conversion rights embedded in equity-linked debt securities allow the issuer to offer investors a lower yield than a nonconvertible corporate bond, implying that the issuer can raise capital at relatively lower financing costs [2
]. Second, if the common share price rises above the conversion price and the conversion rights are exercised, then the issuers can expect their debt ratio to decrease as the debt becomes capitalized [3
] (see endnote 2 in Appendix B
Firms with low creditworthiness, but high growth potential, may maximize their profit using these characteristics. In the early stage of business cycle, the issuer pays a lower coupon to its investors. After the firm generates profits from the business and the share price rises accordingly, investors may exercise their conversion rights to obtain the difference between the share price and the conversion price or receive a stream of dividend income thereafter. In this regard, equity-linked debt provides the advantage of distributing the risk of cash outflows over time compared to the case of the issuance of general corporate bonds where relatively high interests should be paid to the investors from the beginning of the business cycle, or the case of a paid-in capital increase where issuers have a burden of paying dividends even before the profit is generated. Therefore, equity-linked debt is used as a channel for raising capital for small businesses [4
]. From an investor’s perspective, they also have the advantage of being a tool to mitigate agency conflicts between shareholders and creditors caused by information asymmetry. In general, shareholders with limited liability to the firm are likely to be motivated to maximize their value by allocating resources in investments with relatively high risk, but high expected returns. Accordingly, creditors who invest in general corporate bonds issued by the company may be threatened by such actions. In contrast, equity-linked debt with embedded conversion features can help protect investors’ rights by aligning the direction of future cash flows with those of the shareholders [5
In addition to the inherent characteristics of equity-linked debt, the recent macroeconomic market conditions and policies of financial authorities in Korea also contributed to the rapid growth of the equity-linked debt market. First of all, the environment of the financial market, where expected returns have been declining such as the recent low interest rate trend or the stock market that has not shown a clear direction, have led to large investment in this market. The authorities’ policy to promote the growth of the venture companies and SMEs has also had a significant influence on the expansion of the base of equity-linked debt investors. In particular, the KOSDAQ Venture Funds, which was launched in 2018, have contributed to the inflow of funds into the equity-linked debt market as it was required to invest more than 50% of the total fund in stocks or equity-linked debt of venture companies and KOSDAQ-listed firms.
While the equity-linked market clearly serves as a much-needed source of funds for small and financially distressed companies, it is also true that there are concerns in the market about the rapid growth. Basically, since the exercise of the conversion rights in CBs or BWs occurs when the stock price is higher than the conversion price, it is inevitably accompanied by a transfer of the existing shareholders’ wealth to those exercising their conversion rights [10
]. Numerous previous literature analyzes the announcement effects of CB and BW offerings and mostly report negative market responses. Dann and Mikkelson [13
] analyze 132 CBs issued by 124 firms in US market and show that significant negative cumulative return after the issuance announcement. Following literatures [2
] also report similar negative announcement effect of CB offerings. Ammann et al. [25
] find evidence that the announcement effects of CBs and EBs (exchangeable bonds) are negative and significant in Germany and Switzerland. Duca et al. [26
] show that the negative announcement effects of CBs are more than twice in the period from 2000 to 2008 than in the period from 1984 to 1999. For BW, Long and Sefcik [2
] and Phelps et al. [21
] report significant negative market reactions to issuance announcement. On the other hand, relatively few but some opposite results are reported. Kang and Stulz [27
] find significant positive announcement effect of CB and BW offerings in Japan, and Abhyankar and Dunning [28
] and Kim and Han [29
] show positive market responses to CB issuance announcements for the purpose of capital expenditure in UK and Korea, respectively. Billingsley et al. [30
], Jayaraman et al. [31
], and Roon and Veld [32
] also report positive or insignificant announcement effect of BW offerings.
Another concern of market participants is that a provision, specifically refixing option, generally embedded in many recently issued equity-linked debts potentially makes the dilution of existing shareholders’ wealth worse. The refixing option embedded in equity-linked debt allows for the adjustment of the conversion price in line with a fall in stock prices. Consequently, investors can make profits even if the stock price of issuing firm falls under the conversion price at the time of issuance. On the other hand, existing shareholders face situations where not only the stock price declines but the dilution of the stock value increases due to the exercise of the conversion rights. In particular, while Article 5-23 of Regulations on Issuance, Public Disclosure, etc. of Securities stipulates that the conversion price after adjustment for a decline in price shall not be less than 70% of the conversion price at the time of issuance, at the same time, Article 5-23 also specifies that the conversion value can be adjusted less than 70% if articles of incorporation stipulate that matters concerning the adjustment of conversion price shall be determined by a special resolution at the general meeting of stockholders, and if the general meeting of stockholders determines the minimum adjusted price and the amount of bonds specifically. This implies that the conversion price can be easily adjusted to the par value of stock according to the will of majority shareholders. Actually, the downward adjustments of conversion price to less than 70% of initial conversion price have been observed in many recent cases. While only 16% of the total issuances are allowed to adjust the conversion price less than 70% among the equity-linked debt issued from 2000 to 2016, this proportion increases to about 33% from 2017 to 2018.
Regarding the discussion above, an interesting pattern is found in the recent expansion of equity-linked debt market in Korea. That is, BWs had been mainly issued until 2013, and after that, it is completely converted to a CB-centric issuance market. The reason for this change can be found in the ban on issuance of detachable BW in 2013 (see endnote 3 in Appendix B
). The detachable BW (or bond with detachable warrant) refers to equity-linked debt that can be sold separately from the bond for the right to buy the underlying asset. The majority shareholders or the related third party may buy back the warrants separately from investors and want to exercise them to enhance their control rights. Kim et al. [33
] also find the evidence that are less consistent with the last resort financing hypothesis, but rather consistent with the control enhancing hypothesis in Korea. The Korean financial authorities, therefore, banned the issuance of detachable BW because the right and interest of existing shareholders could be infringed if the major shareholder set the exercise price low and then purchase the detachable warrant to increase their stake. However, since CB with call provision can replicate the functionality of detachable BW, investors recognized BW and CB as practically the same instruments and replaced BW with CB after 2013. The call provision embedded in CB means the right of an issuer or a third party designated by the issuer to buy back the security issued within the contracted amount from the investors.
While this unique characteristic provides meaningful implication to raise capital of firms, only a few researches have been reported because equity-linked debts with embedded the refixing option are almost issued only in Korea and Japan [34
]. In the U.S. market, “death spiral convertible bonds” or “floating-priced convertible bonds” are somewhat similar to the CBs with the embedded refixing option. However, they are different in terms of the adjustment mechanics that it is automatically adjusted according to the conversion rate predefined in the prospectus. In addition, only 326 of floating-priced convertible bond from 30 firms are issued in the U.S. market from 2010 to 2016, which is smaller than the number issued in the Korean market in 2016 [35
Related literatures argue that the refixing option is a provision that gives an advantage to investors. Yoon [34
] raises the issue of the system of privately placed detachable BWs and reports that the largest shareholder can obtain an average annual return of 460% by using the refixing option. Byun and Park [36
] show that the announcement effect of CB offerings containing the refixing option is reported to be a greater negative than the refixing option is not included. Yoon [34
] analyzes privately placed detachable BWs where the affiliated persons, including the largest shareholder, repurchase warrants and shows that the announcement effect is negatively significant and the affiliated persons can obtain additional return of 674% by using the refixing options. Based on these findings, Yoon [37
] suggests to reduce the advantage of the refixing option or apply the differentiated refixing range of the exercise price.
Accordingly, this study analyzes the announcement effect of equity-linked debt with the embedded refixing option. To do this, the cumulative abnormal returns are calculated around the issuance disclosure of all CBs and BWs recorded in the Financial Supervisory Service (FSS) Disclosure System from January 2001 to December 2018 as market responses. Then, the effect of the inclusion of a refixing clause on the market responses are examined with the firm-, issue-, and market-specific control variables.
The main findings of this study are as follows. First, the stock market investors lower the value of firms issuing equity-linked debt with the refixing option by 2.6 to 2.7 percentage points in terms of the cumulative abnormal return over the period (−1, +1) around the announcement, compared to those without the refixing option. This result indicates that market concern about the dilution of existing shareholder value due to the downward adjustment of conversion price resulting from the stock price decline are effectively reflected in the valuation. I further find that the negative market response on the inclusion of the refixing clause strengthens in the recent period (2016–2018), with 6.2 to 6.3 percentage point discounts on the value of such firms. Second, the effect of refixing option occurs intensively when the macroeconomic environment deteriorates. I find that the negative market responses to the refixing option are only significant when the indexes of macroeconomic conditions worsen or the negative effects are reduced under the speculative period. Third, while the type of equity-linked debt issued does not affect the market response to the refixing option, the negative effect differs depending on the stock exchange to which the issuer belongs. The market responses to the firms listed on the KOSDAQ market are lower by 1.3 percentage points than those of KOSPI-listed firms.
This paper offers several contributions to the literature that differ from those of previous studies. Yoon [34
] examines the market response to the refixing option and warrant-repurchase by the largest shareholder and affiliated persons, but limits the study to bonds with warrants, and analyzes data prior to August 2013, that is, before the detachable BWs were banned. Byun and Park [36
] also analyze the announcement effect of CB offerings with the refixing option, but not those of BW offerings and covers CB announcements until 2015, a period before the rapid increase in CBs issuance. In addition, the mentioned studies have a limitation in that they show the negative market reaction to the inclusion of the refixing option through univariate analysis. On the other hand, this study comprehensively examines the effects of inclusion of the refixing clause in BW and CB offerings during the period from 2001 to 2018 with particular emphasis on the recent period from 2016 to 2018, when the amounts of issuance increased rapidly using multivariate analysis. In particular, since CBs have replaced BWs due to the change in the regulation and these two products has been recognized by investors as instruments of practically same function, it is deemed essential to examine them in an integrated manner to analyze the equity-linked debt market in Korea.
This paper is organized as follows. Section 2
develops the hypotheses of this paper and discusses the research methodology. Section 3
introduces the results of the empirical analyses. Section 4
concludes the paper.