Cost of Financial Distress on Financing Strategy of Callable Bonds

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초록

This paper theoretically explores the effect of cost of financial distress on the design and calling of a bond.
A callable bond, in this paper, represents both callable non-convertible bonds and callable convertible bonds. This paper adopts a game model of the manager-shareholder and the bondholder, wher the former is a strategic player and the latter is a price-taker.
Regarding callable non-convertible debt, the model predicts that, in equilibrium, a firm defaults with the same probability as in the case of issuing the optimal standard bond. It implies that a callable non-convertible bond has no relative advantage over a standard bond when the cost of financial distress is considered.
However, the model provides an interesting implication regarding the timing of call that a call price applicable at a later time is relatively higher than a call price applicable for an earlier time as the cost of financial distress is larger. It implies that a firm should expect to pay relatively higher call price if it calls a bond later instead of calling right now. Thus, a firm is less likely defer calling because the marginal benefit of deferring is lower. This result can be explained by that a firm issues a callable bond to reduce the chance of financial distress. Calling a non-convertible bond tends to be expedited when the cost of financial distress is large. Calling entails recapitalization. By exercising a call option embedded in a bond, a firm repays outstanding debts and raise new funds. It tends to have a stronger incentive to exercise call options early and thus avoid financial distress since the cost of financial distress is larger.
On the other hand, the model shows that a firm remains bond-financed in a strictly larger set and defaults in a strictly smaller set of realized states in an intermediate period if it issues a callable convertible bond instead of a non-convertible bond. A firm is defined to remain bond-financed if a bond was issued in the beginning and has been neither called nor converted. Thus, a callable convertible bond enhances, if any, the benefit of bond-financing because a firm remains bond-financed with higher probability. It also mitigates cost of default because a firm defaults with lower probability. This result is driven by the design of a convertible bond. A convertible bond is designed to be converted if the return of a firm is relatively poor.
This implies that, if information asymmetry is incorporated, a relatively good firm may issue a callable non-convertible bond for signaling while a relatively poor one issues a callable convertible bond. A good firm can incur signaling cost by issuing a non-convertible bond because a non-convertible bond has relative disadvantage. A poor firm chooses to be separated by issuing a convertible bond if it is better off.
It also explains the relatively poor performance of firms around a call of convertible debt reported by existing literature. This may be further interpreted as implying that a call conveys negative information.
In equilibrium, cost of financial distress ambiguously influences a sequence of call prices contrary to a non-convertible bond. Thus, the theoretical prediction about the effect of cost of financial distress on calling a convertible bond is ambiguous. A firm need not hurry calling to recapitalize because it becomes equity-financed and, therefore, free from default risk once a convertible bond is forced to be called.

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