Debt Issuance under Rule 144A and Equity Valuation Effects. Peter Carayannopoulos and Subhankar Nayak* (Preliminary Draft, April 2010) ABSTRACT

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1 Debt Issuance under Rule 144A and Equity Valuation Effects by Peter Carayannopoulos and Subhankar Nayak* (Preliminary Draft, April 2010) ABSTRACT The paper examines the motives for issuing debt under Rule144A as opposed to issuing in the public market. We believe our results provide a significant contribution to our understanding of the particular market. Our findings suggest that while issuers of nonconvertible debt under Rule 144A do so in an attempt to benefit from general favorable market conditions, issuance of convertible debt under Rule 144A is influenced by an issuer s prior stock run up. Announcement effects are also different between issuers of convertible and nonconvertible debt under Rule 144A when compared to announcement effects of issuers in the public market; while there is an incremental positive announcement stock effect associated with the issuance of nonconvertible debt when compared to public issuance, issuers of convertible debt under Rule 144A experience a negative stock effect over and above any effects associated with issuance of convertible debt in the public market. EFM Classification Code: 230, 340 Keywords: Corporate Debt Financing, Rule 144A * Wilfrid Laurier University, School of Business and Economics, Waterloo, Ontario, Canada, N2L 3C5. Peter Carayannopoulos can be contacted at pcarayanno@wlu.ca and Subhankar Nayak at snayak@wlu.ca. This is preliminary work. Please do not quote without the authors permission. 1

2 Debt Issuance under Rule 144A and Equity Valuation Effects 1. Introduction In this line of research we explore factors that affect the decision to issue corporate debt under Rule 144A as opposed to issuing in the public market, a practice that has experienced significant growth over the past few years. Based on our findings, we develop and test propositions regarding the issuer s stock behavior following the announcement of the method of the debt financing. To our knowledge this is the first study that links an issuer s motives for issuing debt under Rule 144A with the market s reaction following announcement. We believe our findings make a significant contribution to our understanding of the particular market, and our results are of particular importance to market participants, i.e., issuers, investors and regulators. The US Securities Act of 1933 stipulates that all offers and sales of securities must be registered with the Securities and Exchanges Commission (SEC) unless a registration exemption is available. The most common exemption used is a combination of Section 4(2) and Rule 144A of the Securities Act. Section 4(2) provides an exemption to registration for securities that are only offered privately, and do not constitute a public offering. Thus, securities offered under Section 4(2) are not eligible for resale. In April 1990 the Securities and Exchanges Commission (SEC) approved Rule 144A which provided a further exemption to securities issued under Section 4(2). Under Rule 144A securities issued under Section 4(2) could be resold to certain qualified institutional buyers (QIBs) as long as certain conditions are met. QIBs include sophisticated market participants such as mutual funds, hedge funds, investment portfolios that meet certain size criteria. 1 Several papers have documented a tremendous increase in Rule 144A issuance since its 1 For a more detailed description and the origins of the Rule 144A market please see Livingston and Zhou (2002), 2

3 introduction. The increase is associated mainly with the high-yield corporate bond market. While less than 15% of high-yield corporate bonds were issued through Rule 144A in 1993, by 1997 this number had grown to more than 80 percent (Fenn, 2000). Livingston and Zhou (2002) suggest that the increase seems to have come at the expense, at least partially, of the private placement market. Total annual dollar value of new debt issues under Rule 144A grew from $3.39 billion in 1990 to $235 billion (adjusted for inflation) by At the same time the traditional private placement market shrunk from $110 billion in 1990 to $51 billion in Huang and Ramirez (2009a) underline the importance of the Rule 144A market with respect to convertible bond issuance: while less than 20 percent of convertibles were issued under Rule 144A in 1991, the percentage increased to 89 percent by The existing literature provides two possible explanations for the growth in the market: the first one suggests that speed of issuance is the main driving force behind the growth in the market. Firms choose the particular market since it allows them to issue the securities quickly thus, taking advantage of favorable conditions in the market. This is of particular importance to lower credit quality firms trying to satisfy pressing needs. Fenn (2000) suggests that more than 80 percent of non-investment grade bond offerings in 1997 by US firms took place in the Rule 144A market. Huang and Ramirez (2009a) document a migration of convertible debt offerings from the public to the Rule 144A market during the period from 1991 to 2004; while in 1991, one year after the introduction of Rule 144A, approximately twenty percent of convertible bonds were issued in the Rule 144A market the number grew to more than 80 percent by The second explanation has to do with lender specialization: QIBs which are sophisticated market participants have significant advantages in producing and processing information as well as efficiencies in dealing with financial distress. While these lenders are likely to obtain and exploit an informational monopoly over their Chaplinsky and Ramchand (2004) and Zoubek and Rosen (2008). 3

4 borrowers, it is possible that for non-investment grade borrowers the advantages of borrowing from QIBs outweigh the disadvantages. Huang and Ramirez (2009b) find support for both the speed of issuance and lender specialization arguments as main reasons for the tremendous growth in the Rule 144A market. A number of studies examine yield differential for domestic debt issuers between the public and Rule 144A debt markets. Fenn (2000) finds that although present at the early stages of the 144A debt market, yield premiums quickly vanished over time. He also finds that investors require a premium from first-time issuers regardless of whether they issue in the public or the 144A markets. Livingston and Zhou (2002), however, suggest that Rule 144A bond issues have higher yields to maturity than publicly issued debt. They attribute this to lower liquidity of, information uncertainty and weaker legal protection for investors. Chaplinsky and Ramchand (2004) examine differences for international firms issuing debt in the US market. They find that while yields for investment grade debt offered in the 144A market are higher than comparable issues offered in the public market, there are no differences in high yield offerings in either market. They suggest the existence of a bifurcation of the markets where high quality firms issue in both markets but face higher yield spreads in the 144A market and low quality firms that issue only in the 144A market. Ackert and Ramirez (2005) compare yield spreads for public, Rule 144A and private collateralized obligations and their determinants. Their evidence is consistent with yield premiums for Rule 144A over the public collateralized obligations markets but lower premiums when compared to the equivalent private market. With respect to the Rule 144A convertible bond market, Huang and Ramirez (2009a), after controlling for credit risk, asymmetric information, market conditions, and issue characteristics, find no differences in gross spreads, offering yield and announcement effects between the 144A and public convertible bond markets. Their results suggest that market 4

5 participants view both markets as comparable with similar issuing costs. While it is evident from the discussion above that previous research has focused mainly on the characteristics of the debt issue, associated costs in the form of yields offered, and reasons for issuing in the 144A market, very little has been done in terms of exploring the presence of any wealth effects associated with debt issuance in the 144A market. Huang and Ramirez (2009a) find no differences in announcement effects between the public and Rule 144A markets for firms issuing convertible bonds for the period from 1991 to We present a comprehensive study of the motives for issuing in one versus the other markets and explore differences in wealth effects following announcement. Our main findings suggest that while for convertible bond issuers an issuer s prior stock run-up increases the probability of issuing in the Rule 144A market versus the public market, for nonconvertible bond issuers the factors affecting the decision are related mostly to taking advantage of favorable market conditions in general rather than the prior behavior of the issuer s stock. Consequently, we find that issuers of convertible bonds under Rule 144A experience a negative stock reaction around the announcement day, over and above any reaction experienced by issuers of convertible bonds in the public market. Our results are different than the ones suggested by Huang and Ramirez (2009a) and this can probably be attributable to the fact that our study focuses on a more recent, although overlapping, time period (2000 to 2006 versus 1991 to 2004) during which convertible bond issuance under Rule 144A has experienced tremendous growth. On the contrary, issuers of nonconvertible debt under Rule 144A experience a positive stock reaction around the announcement day over and above any effects associated with issuance in the public market. The rest of the paper is structured as follows: section 2 provides a description of our sample; in section 3 we examine the factors affecting the choice between public and Rule 144A issuance; in 5

6 section 4 we explore differences in an issuer s stock behavior around the announcement of the debt issue while section 5 describes differences in the stock performance of firms issuing in the Rule 144A versus the public markets for a period of a year following the announcement of the debt issue. Finally a summary of our findings is presented in section Data Description Our sample includes corporate US bond issues issued during the seven year period from 2000 to Detailed issue, issuer and issuance-related information were obtained from the Mergent Fixed Investment Securities Database (FISD). Issuers stock prices prior and after bond issuance were obtained from the CRSP database. Thus, our sample excludes issues that did not have any matching stock in CRSP. It also excludes bonds with missing offer dates, missing identifiers with respect to convertibility status and Rule 144A status, Yankees, foreign currency issues, Eurobonds or agency type bonds. We also dropped issues under defeased or defaulted status. Table 1 provides summary information for our sample. Overall our sample includes 3,764 non-convertible and 1,091 convertible issues for a total of 4,855 bonds. Of these bonds 3,010 were issued in the public market (2644 non-convertible and 366 convertible) and 1,845 were issued under Rule 144A (1,120 nonconvertible and 725 convertible). The total offer amount for the 4,855 bond issues was approximately $1.9 trillion of which almost 1.5 trillion was non-convertible. Public issues accounted for approximately $1.27 trillion ($1.125 non-convertible and $147 billion convertible) and Rule 144A accounted for approximately $590 billion ($363 billion non-convertible and $227 billion convertible). 3. Prior Stock Run-Up and Choice between Rule 144A versus Public Issuance 6

7 There is an extant body of literature examining whether managers are able to time the market and lower the firm s cost of capital. If managers are able to time the market, proxies of misevaluation should be correlated with the timing of the security issuance decision. For example, Loughran and Ritter (1995) and Spiess and Affleck-Graves (1995) find that companies issuing equity significantly underperform the market for a period of five years after issuance. Spiess and Affleck-Graves (1999) suggest that firms that are overvalued are likely to issue securities of any type, and debt offerings, like equity offerings, are a signal that the firm is overvalued (pg. 46). Baker and Wurgler (2002) suggest that market timing is an important aspect of real financing decisions and that capital structure is the cumulative outcome of previous attempts to time the market. Elliot, Koeter-Kant and Warr (2008) find empirical support that equity mispricing plays a significant role in the security choice decision. They suggest that firms with overvalued equity are more likely to issue equity, while those with fairly valued or undervalued equity are more likely to issue debt. Given its hybrid nature, convertible bond issuance should also be influenced by similar factors. Lewis, Rogalski, and Seward (2003) suggest that stock market reaction depends on the convertible security design and the extent to which the security is debt-like versus equity-like. While a large number of studies examine the decision criteria with respect to the different forms of financing, very few deal with the factors that affect the decision to issue under Rule 144A versus the public market. We examine this issue for issuers of debt, both straight and convertible. Speed of issuance in the Rule 144A versus the public debt market allows an issuer to exhibit a more opportunistic behavior that takes advantage of favorable conditions that may exist. The conditions can be related to the valuation of the issuer s stock prior to the announcement of the issue or other non stock related factors such as general favorable debt market conditions, pressing needs, etc. If 7

8 markets perceive that the choice of issuing under Rule 144A is based on the belief that the stock is overvalued such issuance should be associated with negative stock effects following the announcement of the issue. However, if the perception is that the firm is trying to take advantage of favorable conditions in the market other than an overvalued stock then issuance under Rule 144A should be associated with positive stock effects following the announcement of the debt issue under Rule 144A. Lender specialization, also associated with the issuance under Rule 144A, enhances these inferences. Normally, the presence of QIBs, and their superior ability to produce and process information, should reduce information asymmetries which should result in a positive stock impact following announcement. However, if the choice is perceived to be related to an overvalued stock, the QIBs significant advantages in producing and processing information will allow them to take advantage of such misevaluation through arbitrage strategies that they can easily develop. Capital structure and convertible bond arbitrage are such examples. In order to determine whether prior abnormal stock behavior is associated with the choice of the debt market, Rule 144A versus public, we employ an event study methodology approach and we measure the issuer s stock performance during a preannouncement period of 250 to three trading days prior to the announcement day, [-250, -3]. With respect to the estimation of the stock performance, Lyon, Barber and Tsai (1999) recommend using buy-and-hold abnormal returns (BHAR), whereas Mitchell and Stafford (1998) and Fama (1988) favor cumulative abnormal returns (CAR). In this paper we use the latter approach and we measure a stock s excess market reaction using the market model suggested by Brown and Warner (1985). Thus, over a period [t 1,t 2 ] we calculate a stock s CAR as t C AR t, t R R, i, t m, t t t 1 8

9 where R i,t is the stock price return of the bond issuing firm i on day t, R m,t is the return on the CRSP value-weighted market index on day t, and t denotes the trading day relative to the event day. Our results are depicted in Table 2. In Panel A the sample is partitioned with respect to convertibility status of the issued bond, and further partitioned with respect to whether issuance took place in the public or Rule 144A markets. Convertible bonds are further classified with respect to the moneyness of the embedded conversion option in Panel B; In line with the Lewis, Rogalski, and Seward (2003) arguments we believe that this classification is important since when the option of the convertible bond is deep out of the money the value of the embedded option is lower and the bond behaves more like regular debt rather than equity; however the more the option is in the money the more the bond should exhibit an equity-like behavior. In line with this observation, the stock of bond-like convertible bond issuers should exhibit behavior similar to the behavior of other nonconvertible bond issuers. Ceteris paribus, the stock of equity-like convertible bond issuers should exhibit behavior similar to other pure equity issuers. We classify the convertible bonds as bond-like if the ratio of the bond s conversion value to the bond s par value is less than or equal to 80 percent and equity-like otherwise. Our results provide strong evidence of a significant stock run-up during the [-250, -3] window, both for firms issuing nonconvertible and firms issuing convertible debt. However, the runup associated with the issuance of convertible debt is significantly higher in general than the one associated with the issuance of nonconvertible debt (CARs of 36.83% and 13.48% respectively). Our results, although not adjusted for firm or issue specific characteristics, are in line with results in the prior literature. 2 Furthermore, the stock run-up appears to be more pronounced for issuers in the Rule 144A market than the public and this persists in both the nonconvertible (CARs of and See for example Spiess and Affleck-Graves (1999), Mclaughlin, Safieddine, and Vasudevan (1998), Lewis, 9

10 respectively) and the convertible (CARs of and respectively) markets. Not surprisingly, as data in Panel B suggest, the run-up is much greater for the equity-like convertibles as compared to bond-like convertibles. However, while differences in the stock run up between publicly and Rule 144A issued equity-like convertibles are non-significant, bond-like convertible issuers issuing in the Rule 144A market exhibit significantly higher CARs than the ones issuing directly to the public (CARs of and respectively). While this preliminary examination of CARs suggests the existence of some differences in the pre-issuance stock behavior between firms issuing in the public versus the Rule 144A markets, it is not clear whether these differences are due to the type of firm attracted in each of the two markets and whether these differences persist after adjusting CARs for individual firm characteristics. After all, as noted earlier, firms issuing in the Rule 144A market are mainly lower quality, higher yield, non-investment grade issuers. In order to better assess the impact of prior abnormal stock behavior on the choice of issuance in the public versus the Rule 144A markets we employ the following twostage regression: CAR[-250, -3] i = a + β 1 (Age i ) + β 2 (Tobin s_q i ) +β 3 [Ln(Mkt_Cap i )] + β 4 (Debt_Ratio i ) + β 5 (Vol i ) + β 6 (Fin_Flag i ) + β 7 (Utl_Flag i ) + ε i (1) Rule _144A_Flag i = a + γ 1 (Adj_CAR i ) + γ 2 (Age i ) + γ 3 (Tobin s_q i ) + γ 4 [Ln(Mkt_Cap i )] + γ 5 (Debt_Ratio i ) + γ 6 (Vol i ) + γ 7 (Fin_Flag i ) + γ 8 (Utl_Flag i ) + γ 9 (TERM) + γ 10 (DEF) + γ 11 (Int_Rate) + γ 12 (TTM i ) + γ 13 (Spread i ) + γ 14 (Rel_Size i ) + γ 15 (Conv_Ratio i ) + ε i (2) Regression (1) adjusts a firm s CAR observed during the pre-announcement period for specific firm i characteristics such its age on announcement date in years (Age), ratio of market value to recorded assets value (Tobin s_q), the logarithm of its total market capitalization (Ln(Mkt_Cap)), Rogalski and Seward (2003). 10

11 its debt ratio (Debt_Ratio), and the firm s volatility prior to announcement (Vol). 3 Two dummy variables are also included, one to denote a financial firm (Fin_Flag) and the other a utility firm (Utl_Flag). Our results suggest that Age, Tobin s Q, Ln(Mkt_Cap), Debt Ratio, and Vol are all significant and explain a significant portion of the CARs observed during the pre-announcement period. 4 Regression (2) is used to evaluate whether the unexplained portion of a firm s CAR (Adj_CAR) during the pre-announcement period, i.e., the unexplained residual from regression (1), has any influence in the decision to issue in the Rule 144A versus the public markets along with other firm specific, market specific and issue specific characteristics. Rule_144A_Flag, the explanatory variable in regression (2), is a binary variable that takes the value of 1 if the firm issues in the Rule 144A market and zero otherwise. As well as Adj_CAR, we also include the firm specific characteristics from regression (1). In addition, general market characteristics at the time of the announcement such as the difference between the ten- and the one-year constant maturity Treasury yields (TERM), the difference between Moody s Baa and Aaa rated corporate bond yields (DEF), and the one-year constant maturity Treasury rate (Int_Rate) are included in the regression. 5 Finally we include a set of issue specific characteristics such as the total proceeds from the issue as a percentage of total pre-issue capitalization (Rel_Size), time-to-maturity of the issue (TTM), the yield spread between the offering yield of the issue and the yield on a Treasury of comparable maturity (Spread) and the ratio of the bond s conversion value to the bond s par value (Conv_Ratio). Since the majority of debt issued in the Rule 144A market is unrated, Spread serves as a proxy of the 3 Such firm specific characteristics in various forms have been used in prior studies to adjust returns. For example, please see Ritter (1991). Kang and Lee (1996), Loughran and Ritter (1995), Spiess, and Affleck-Graves (1999), Baker and Wurgler (2002). 4 While they are not included in the paper, results for the particular regression can be available upon request. 5 Livingston and Zhou (2002) and Huang and Ramirez (2009a) use the same or similar variables to capture debt market conditions at the time of issuance. 11

12 rating the issue would have received had it been rated. 6 As discussed earlier, Conv_Ratio is a measure of the moneyness of the option embedded in the convertible bond. Given the binary nature of the dependent variable, we use probit to estimate regression (2). Due to the hybrid nature of convertible bonds we estimate separate regression estimates for non-convertible and convertible debt. 3.1 Factors Affecting Choice in the Nonconvertible Bond Market Results for regression (2) associated with the issuance of nonconvertible debt are depicted in Table 3. Our results strongly suggest that pre-announcement unexplained cumulative abnormal return (Adj_CAR) does not influence the choice between issuing in the Rule 144A versus the public markets. The choice is influenced by specific firm characteristics such as the firm s age, market capitalization, leverage and risk. The coefficients of Age, Mkt_Cap, and Debt_Ratio are negative and significant while Rel_Size, Spread is positive and significant suggesting that the Rule 144A market attracts younger, smaller firms with relatively less leverage in their capital structure and lower ratings (as proxied by Spread). These findings confirm previous assertions with respect to the characteristics of firms issuing in the Rule 144A market. The negative coefficients of Fin_Flag and Util_Flag suggest that financial and utility firms are less likely to issue in the Rule 144A market. The negative and significant coefficient of Int_Rate suggests that firms issuing in the Rule 144A market do try to take advantage of lower interest rates in the market since rising interest rates significantly lower the probability of issuing in the Rule 144A market. However, market related variables such as TERM and DEF do not appear to influence the decision regarding the choice between the Rule 144A and the public markets. 6 Huang and Ramirez (2009b) use an explicit procedure to rate unrated issues. 12

13 Thus far we have explored characteristics that affect the choice between issuing in the Rule 144A and public markets. However, even within the public market shelf-registration has recently gained a lot of attention as a means of speeding up the issuance of a security. Shelf-registration, or issuance under Rule 415, permits a corporation to file a registration for securities it intends to issue within two years of the original registration. Thus, a firm can register an issue today and then sell the securities in the future quickly as conditions and needs warrant. In this respect the public shelfregistration market may be viewed as comparable to the Rule 144A market since it may offer similar speed of issuance benefits to the issuer, once the firm has registered the securities. However, the two markets, Rule 144A and public shelf-registration, are also different from each other in the sense that Rule 144A allows for an immediate speedy issuance, thus taking advantage of ideal firm and market conditions, while Rule 415 allows for a speedy issuance only if a firm has gone into the selfregistration process in the past. In order to investigate any differences in the factors affecting the choice between Rule 144A and Rule 415, regression (2) is run on the sample of issuers under Rules 144a and 415 only. Our results, also depicted in Table 3, are very similar to previous ones when issuance under Rule 144A is compared to issuance in the public market overall. One additional result in this case, is that the coefficient of the yield spread between Baa and Aaa rated bonds (DEF) is negative and significant which further confirms that timing of favorable market conditions is enhanced in the case of issuance under Rule 144A and the speed of issuance it allows. Overall, our results suggest that with respect to nonconvertible bond issuers prior stock performance does not appear to influence the decision to issue in the Rule 144A market versus the public market. Our results suggest that firms issuing under Rule 144A as opposed to issuing in the public market are younger, smaller, with lower debt levels but higher risk that try to take advantage of favorable debt market conditions such as the level of interest rates and/or spreads between high 13

14 and lower quality issuers. 3.2 Factors Affecting Choice in the Convertible Bond Market There are some striking differences in results, depicted in Table 4, when the convertible bond market is considered. Unlike the findings in the nonconvertible market, it appears that prior stock run-up is the main factor that influences the decision to issue under Rule 144A as opposed to issuing in the public market. The coefficient of Adj_CAR is positive and significant while other debt market specific variables do not appear to influence the decision. When we compare issuance under Rule 144A with issuance under Rule 415 prior stock run-up is still an important factor affecting the decision to issue under Rule 144A. In this case higher interest rates and a widening spreads between 10- and one- year Treasury yields (captured by Int_Rate and TERM respectively) lower the probability of issuing under Rule 144A suggesting better timing with respect to general market conditions under Rule 144A versus Rule 415 issuance. 4. Debt Issuance under Rule 144A and Announcement Effects on the Issuer s Stock The announcement effect of different corporate securities has been the subject of numerous studies. For example, Mikkelson and Partch (1986) study the effects of equity issuance, Eckbo (1986) provides a similar study for debt issuance, while Dann and Mikkelson (1984), Mikkelson and Partch (1986), Billingsley, Lamy and Smith (1990) and Gosh, Varma and Woolridge (1990) provide insight with respect to the issuance of convertible and exchangeable debt. Overall, the previous literature suggests that while the issuance of non-convertible debt is associated with no significant stock price reaction, the issuance of equity is associated with a significantly negative reaction of the 14

15 issuer s stock price. Given its hybrid nature, the issuance of convertible bond is also associated with a significantly negative reaction of the stock price. The negative reaction is more pronounced for equity-like convertible issues (although smaller than that of pure equity issues) and less so for more debt-like convertibles. These results support models proposed by Myers and Majluf (1984), Brennan and Kraus (1987) and Kim (1990) that predict a negative relationship between the announcement effect and the equity component at the issue. In this section we examine stock announcement effects of issuers of debt under Rule 144A as opposed to issuers of debt in the public market. Given our analysis and results in section 3 we test the following two propositions: P1: The announcement of nonconvertible debt issuance under Rule 144A should have a positive effect on the issuer s stock relative to effects that characterize issuance in the public market. Given the fact that the decision to issue nonconvertible debt under Rule 144A is associated with an issuer s attempt to take advantage of favorable debt market conditions rather than a prior abnormal stock behavior as our findings in the previous section suggest and the reduction of information asymmetry due to the presence of specialized lenders, we expect such announcement to have a positive impact on the issuer s stock when relative to any effects when financing takes place in the public market. P2: The announcement of convertible debt under Rule 144A should have a negative effect on an issuer s stock relative to effects that characterize issuance in the public market. As determined in the previous section, the decision to issue a convertible bond under Rule 144A is influenced by an issuer s prior stock run-up and, thus, associated with an opportunistic behavior regarding the issuer s equity valuation. In such case, the announcement of convertible bond issuance under Rule 144A should have a negative impact on the issuer s stock as compared to the 15

16 impact on issuers of convertible bonds in the public market. We assess the issuer s stock behavior around announcement by calculating the issuer s cumulative abnormal residuals around a -2 to a +2 days window around the announcement day, CAR[-2, +2], using the same methodology as in section 3. Preliminary results, unadjusted for firm and issue characteristics, presented in Table 1, Panel A, suggest that issuance of non-convertible bonds is associated in general with a positive stock reaction while issuance of convertible bonds is associated with negative stock reaction around issuance day. However, these effects are more pronounced for bonds issued in the Rule 144A market. The average CAR for the Rule 144A nonconvertible issues is 0.59 which is significantly higher than the average CAR for public nonconvertible issues (0.20 percent). With respect to the convertible market, firms issuing under Rule 144A exhibited average CAR of percent versus average CAR of percent if issuing in the public market. When the sample of convertible bonds is further partitioned to bond-like and equitylike in Panel B a distinct difference in an issuer s stock behavior emerges: while for equity-like issuers the difference in the CARs is insignificant (-1.96 percent for public versus percent for Rule 144A), there is a significant difference in CARs for bond-like convertible bond issuers. The CAR for bond-like convertible bond issuers in the public market is positive (but insignificant) which is more or less in line with the stock behavior of non-convertible issuers. However, the CAR for bond-like convertible bond issuers in the Rule 144A market is negative and significant (-3.24 percent). It appears that while negative announcement effects associated with the issuance of convertible bonds in the public market are present only when the issued convertible exhibits more equity-like characteristics, Rule 144A convertible issuance is associated with negative announcement effects irrespective of whether the issued convertible exhibits more straight debt or more equity-like characteristics. 16

17 As mentioned earlier, these results are raw results unadjusted for firm and issue specific as well as general market characteristics. In order to test our hypotheses while accounting for such characteristics we estimate the following regression: CAR[+2, +2] i = a + γ 1 (Rule _144A_Flag i ) + γ 2 (Age i ) + γ 3 (Tobin s_q i ) + γ 4 [Ln(Mkt_Cap i )] + γ 5 (Debt_Ratio i ) + γ 6 (Vol i ) + γ 7 (Fin_Flag i ) + γ 8 (Utl_Flag i ) + γ 9 (TERM) + γ 10 (DEF) + γ 11 (Int_Rate) + γ 12 (TTM i ) + γ 13 (Spread i ) + γ 14 (Rel_Size i ) + γ 14 (Shelf_Reg i ) + γ 15 (Conv_Ratio i ) + ε i (3) where CAR[+2, +2] i is the cumulative abnormal residual for firm i for the period of two days prior to two days after announcement (calculated the same way as described in section 3) for all debt issuers, Shelf_Reg j is a dummy variable indicating issuance under Rule 415 with the rest of the variables as described in regression (2). Regression (3) is estimated separately for nonconvertible and convertible bonds and results are reported in Table 5. Consistent with P1, issuance in the nonconvertible market under Rule 144A is associated with significant positive announcement effects. As a matter of fact Rule _144A_Flag is the only variable that has explanatory power among all the variables used in our regression model. Consistent with P2, our results, depicted in Table 5, suggest that the announcement of convertible debt issuance under Rule 144A is associated with a significant negative stock effect. It is possible that the announcement effects with respect to convertibles issued under Rule 144A can be attributed, at least partially, to convertible arbitrage strategies that have increased in popularity during the last ten, fifteen years. The most common convertible arbitrage strategy involves buying a company s convertible bond and hedging the equity risk by taking a short position in the company s equity. The estimated number of convertible bond arbitrage hedge funds grew from less than thirty in 1995 to more than 250 by the end of 2003 (Agarwal, Fung, Loon and Naik, 17

18 2009). A number of papers have explored the efficiency of such convertible arbitrage strategies. 7 Since purchasers of Rule 144A securities are sophisticated QIBs, hedge funds among them, who have the capability of putting in place such elaborate strategies, such activity might be a lot more intense in the Rule 144A market than the public one. To assess whether such activity drives differences between the public and the Rule 144A debt markets we calculate changes in short interest around the announcement date. In particular we calculate the percentage change in short interest as the difference between the short interest at the end of the announcement month and the average short interest for the three months prior to the announcement month divided by the average short interest for the three months prior to the announcement month. In general there is a significant percentage increase in short interest for issuers in the convertible market. The percentage increase is significantly higher for issuers in the Rule 144A versus the public market, percent versus percent. To investigate whether the negative announcement effect is associated with activities in the convertible arbitrage market we repeat regression (3) including the percentage change in short interest as an additional explanatory variable. The coefficient of the percentage change in short interest is insignificant while the Rule_144A_Flag remains negative and significant suggesting that convertible arbitrage cannot explain the negative announcement effect associated with issuance under Rule 144A. 5. Debt Issuance under Rule 144A and Post-Announcement Effects on the Issuer s Stock Spiess and Affleck-Graves (1999) suggest that the market appears to under-react at the time of the announcement of the debt issue and the full impact of the offering is realized over a longer 7 See for example Henderson (2005), Agarwal, Fung, Loon and Naik (2009), Fabozzi, Liu and Switzer (2009) 18

19 period of time. They find that both nonconvertible and convertible debt issuance is associated with a negative stock reaction in the 5 year period following the debt issuance. The post-issue underperformance of nonconvertible debt issuers is concentrated among smaller, younger, and Nasdaq-listed firms. Lee and Loughran (1998) and Eckbo, Masoulis, and Norli (2000)report similar results for convertible debt issuers. Henderson (2005) finds that convertible bond issuers outperform a benchmark portfolio during the year following issuance although this pattern reverses when the post-event window is extended to five years. We examine the post-announcement stock performance of issuers of debt under Rule 144A versus issuers of debt in the public by calculating the abnormal cumulative residuals for both a +3 to +125 trading days window and a +3 to +250 trading days window following the announcement of the issue, CAR[+3, +125] and CAR[+3, +250]. Raw results, unadjusted for firm and issue specific as well as market characteristics, are presented in Table 1. Issuers of nonconvertible bonds exhibit positive stock reaction during both the [+3, +125] and the [+3, +250] post- announcement periods. There are no differences between issuers in the public and the Rule 144A markets. For convertible bond issuers, however, post-announcement stock performance is not significant for either period considered. However, when the convertible sample is partitioned to bond-like versus equity-like convertible issuers some distinct differences emerge. Post-announcement performance for bond-like convertible issuers is positive and very similar to performance of regular non-convertible bond issuers. There is no difference between issuers in the public versus the Rule 144A markets. For equity-like convertible issuers, the post-announcement stock performance is negative (but not significant) with CAR values of percent and percent for the [+3, +125] and [+3, +250] periods respectively. There are no significant differences in this case between issuers in the public and Rule 144A markets. 19

20 In order to adjust our results for firm and issue specific as well as market characteristics, we estimate regression (3) using CAR[+3, +250] as our dependent variable. Our results, depicted in Table 6, suggest that there is no difference in the stock performance of issuers of debt under Rule 144A for the year following the announcement of the issue when compared to the stock performance of issuers in the public market. The coefficient of Rule_144A_Flag, although negative, is insignificant both for nonconvertible and convertible bonds. 6. Summary Prior literature with respect to debt issuance under Rule 144A has focused primarily on the characteristics of the debt issue, associated costs in the form of yields offered. However, little has been done in terms of exploring the presence of any wealth effects associated with debt issuance in the 144A market when compared to issuance in the public market. In this study we fill this gap by examining first whether the decision to issue debt under Rule 144A as opposed to issuing in the public market is influenced by the issue s stock behavior prior to the announcement of the issue and second we examine announcement and post-announcement stock effects for firms issuing debt under Rule 144A as compared to firms issuing debt in the public market. Our findings suggest that when it comes to issuing nonconvertible bonds prior stock runup does not influence the choice of issuing under Rule 144A versus issuing in the public market. Issuers of straight debt under Rule 144A are younger, smaller and generally riskier firms that attempt to take advantage of general favorable market conditions while they time their issuance in order to take advantage of a prior stock run-up no more than their counterparts issuing in the 20

21 public market. Our results, however, are different when the convertible bond market is examined. It appears that a prior stock run-up increases the probability of issuing under Rule 144A versus issuing in the public market. With respect to differences in the announcement effect, issuers of nonconvertible debt under Rule 144A experience a significant positive abnormal return when compared to their counterparts issuing in the public market. The result can be attributed to a reduction in the informational asymmetry that may exist given the lender specialization hypotheses and the involvement of QIBs in the purchase of the security being issued. Unlike the nonconvertible bond market however, there is a significantly negative stock return around the announcement of the issuance of convertible debt under Rule 144A over and above any effects associated with the issuance of convertible debt in the public market. This could be the market s reaction to the belief that firms issuing convertible under Rule 144A are exhibiting a more opportunistic behavior especially since it is found that the decision to issue under Rule 144A is influenced by an issuer s prior stock run-up. Finally, our findings suggest that there are no differences in the stock performance of issuers under Rule 144A versus issuers in the public market for a period of up to a year following announcement. This result holds for both nonconvertible and convertible debt issuers. 21

22 References Ackert, L.F. and G.G. Ramirez (2005): The Evolving Market for Debt under Rule 144A: The increasing Importance of Collateralized Obligations, Working Paper. Agarwal, V., Fung, H. W., Loon, C. Y. and N. Y. Naik (2009): Risk and return in Convertible Arbitrage: Evidence from the Convertible Bond Market, Working Paper, Feb 2009 Version. Baker, M. and J. Wurgler (2002): Market Timing and Capital Structure, Journal of Finance, 57, Barber, B. M., and J. D. Lyon (1997): Detecting Long-Run Abnormal Stock Returns: The Empirical Power and Specification of Test Statistics, Journal of Financial Economics, 43, Billingsley, R. S., Lamy, R. E. and D. M. Smith (1990): Units of Debt with Warrants: Evidence of the Penalty-Free Issuance of an Equity-like Security, Journal of Financial Research, 8(3), Brennan, M. and A. Kraus (1987): Efficient Financing Under Asymmetric Information, Journal of Finance, 42(5), Brown, S. J., and J. B. Warner (1985): Using Daily Stock Returns: The Case of Event Studies, Journal of Financial Economics, 14, Chaplinsky, S. and L. Ramchand (2004): The Impact of SEC Rule 144A on Corporate Debt Issuance by International Firms, Journal of Business, 77(4). Dann, L.Y. and W. H. Mikkelson (1984): Convertible Debt Issuance, Capital Structure Change and Financing-Related Information: Some New Evidence, Journal of Financial Economics, 13, Eckbo, B.E. (1986): Valuation Effects of Corporate Debt Offerings, Journal of Financial Economics, 15, Eckbo, B.E, Masoulis, R.W. and O. Norli (2000): Seasoned Public Offerings: Resolution of the New Issue Puzzle, Journal of Financial Economics, 56, Elliott, B.W., Koeter-Kant, J. and R.S. Warr (2008): Market Timing and the Debt-Equity Choice, Journal of Financial Intermediation, 17:2, Fabozzi, F.J., Liu, J. and L.N. Switzer (2009): Market Efficiency and Returns form Convertible Bond Hedging and Arbitrage Strategies, The Journal of Alternative Investments, 11(3), Fama, E. F. (1998): Market Efficiency, Long-Term Returns, and Behavioral Finance, Journal of Financial Economics, 49,

23 Fenn, G.W. (2000): Speed of Issuance and the Adequacy of Disclosure in the 144A High-Yield debt Market, Journal of Financial Economics, 56, Gosh, C., Varma, R. and R. Woolridge (1990): An Analysis of Exchangeable Debt Offers, Journal of Financial Economics, 28(1-2), Henderson, B. J. (2005): Convertible Bonds: New Issue Performance and Arbitrage Opportunities, Working paper, University of Illinois at Urbana-Champaign. Huang, R. and G.G. Ramirez (2009a): The Rise of the Rule 144A Market for Convertible Debt Offerings, Financial Management, Forthcoming. Huang, R. and G.G. Ramirez (2009b): Speed of Issuance, Lender Specialization, and the Rise of the 144A Debt Market, Working Paper, Available at Kim, Y. O. (1990): Informative Conversion Ratios: A Signaling Approach, Journal of Financial and Quantitative Analysis, 25(2), Lee, I. and T. Loughran (1998): Performance Following Convertible Bond Issuance, Journal of Corporate Finance, 4, Lewis, C. M., Rogalski, R. J. and J. K. Seward (2003): Industry Conditions, Growth Opportunities and Market Reactions to Convertible Debt Financing Decisions, Journal of Banking and Finance, 27, Livingston, M. and L. Zhou (2002): The Impact of Rule 144A Debt Offerings Upon Bond Yields and Underwriter Fees, Financial Management, 31(4), pp Loughran, T. and J. Ritter (1995): The New Issues Puzzle, Journal of Finance, 50(1), Lyon, J. D., B. Barber, and C. H. Tsai (1999): Improved Methods for Tests of Market Efficiency, Journal of Finance, 54, McLaughlin, R., Safieddine, A., and G.K. Vasudevan (1998): The Long-Run Performance of Convertible Bond Issuers, Journal of Financial Research, 21, Mikkelson, W. H. And M. M. Partch (1986): Valuation effects of security offerings and the issuance process, Journal of Financial Economics, 15, Mitchell, M. L. and E. Stafford (1998): "Managerial Decisions and Long-Term Stock Price Performance," Unpublished Working Paper, University of Chicago Business School Myers, S. C. And N. S. Majluf (1984): Corporate Financing and Investment Decisions When Firms Have Information That Investors Do Not Have, Journal of Financial Economics, Ritter, J.R., (1991): The Long-Run Performance of Initial Public Offerings, Journal of Finance, 23

24 46, Smith, C.W. (1986): Investment Banking and the Capital Acquisition Process, Journal of Financial Economics, 15, Spiess, D. K. and J. Affleck-Graves (1995): Underperformance in Long-Run Stock Returns Following Seasoned Equity Offerings, Journal of Financial Economics, 38, Spiess, D. K. and J. Affleck-Graves (1999): The Long-Run Performance of Stock Returns Following Debt Offerings, Journal of Financial Economics, 54, Zoubek, R. D. and B.J. Rosen (2008): Securities and Exchange Commission Amendments to Rule 144 Implications for Private Offerings of High-Yield debt Securities, Capital Markets Law Journal, June 2008, pp

25 Table 1. Description of Bond Sample Panel A: Number of Issues Per Year Non-Convertible Convertible Issue Year Public Rule 144A Public Rule 144A Total Total Panel B: Amount and Other Bond Characteristics Total Offer Amount ($trillion) Mean Offer Amount ($million) Mean Maturity (years) Mean Coupon Rate Non- Convertible # of Issues Public Rule 144A Total Convertible Public Rule 144A Total

26 Table 2. Cumulative Abnormal Returns Panel A: All Bonds Period (in trading days) Non-Convert. Observations -250 to -3-2 to to to +250 Public 2, * 0.20* 3.22* 4.84* Rule 144A * 0.59* 3.72* 6.76* Difference * * Total * 0.30* 3.35* 5.36* Convertible Public * -1.15* Rule 144A * -3.27* Difference * * Total * -2.57* Difference (in totals) * * * * Panel B: Convertible Bonds Period (in trading days) Bond-like Observations -250 to -3-2 to to to +250 Public * * Rule 144A * -3.24* 3.36* 2.71* Difference * * Total * -2.47* 3.44* 2.38* Equity-like Public * -1.96* Rule 144A * -3.40* Difference Total * -2.80* Difference (in totals) * * * The event is the issuance of the bond (day zero). The cumulative abnormal stock return of the issuer is calculated as the sum over all days in the period under consideration of the differences between the daily return of the issuer s stock and the return of the CRISP equally weighted portfolio. * indicates significance at the 5% level. Difference refers to significance of the difference in abnormal returns between public versus Rule 144A issuance. 26

27 Table 3. Choice between the Rule 144A and Public Market for Non-Convertible Debt Issuers Probit Regression is used. The dependent variable equals one if debt issuance is under Rule 144A and zero otherwise. The independent variables are the age of the firm on announcement date in years (Age), the ratio of market value to recorded assets value (Tobin s_q), the logarithm of the firm s total market capitalization (Ln(Mkt_Cap)), the firms s debt ratio (Debt_Ratio), the firm s volatility prior to announcement (Vol), a dummy variable denoting a financial firm (Fin_Flag), a dummy variable denoting a utility firm (Utl_Flag), the difference between the ten- and the one-year constant maturity Treasury yields (TERM), the difference between Moody s Baa and Aaa rated corporate bond yields (DEF), the one-year constant maturity Treasury rate (Int_Rate), time-to-maturity of the issue (TTM), the yield spread between the offering yield of the issue and the yield on a Treasury of comparable maturity (Spread), total proceeds from the issue as a percentage of total pre-issue capitalization (Rel_Size), and the ratio of the bond s conversion value to the bond s par value (Conv_Ratio). Public Bonds Public Shelf-Reg. Variable Coefficient z-stat. Coefficient z-stat. Adj_CAR (1.56) (1.53) Age (-3.74) (-3.04) Tobins_Q (1.01) (0.72) Ln(Mkt_Cap) (-8.88) (-8.85) Debt_Ratio (-3.67) (-3.61) Volatility (0.57) (2.07) Fin_Flag (-10.28) (-10.32) Util_Flag (-3.63) (-3.50) TERM (-0.82) (-1.50) DEF (-1.08) (-2.92) Int_Rate (-2.82) (-4.28) TTM (-0.95) (-1.73) Spread (5.65) (8.47) Rel_Size (2.52) (3.61) Conv_Ratio Constant (6.25) (8.03) Psuedo R N