Performance following convertible bond issuance

Ž. Journal of Corporate Finance 4 1998 185 207 Performance following convertible bond issuance Inmoo Lee a,), Tim Loughran b,1 a Department of Banking and Finance, Weatherhead School of Management, Case Western ReserÕe UniÕersity, 10900 Euclid AÕenue, CleÕeland, OH 44106-7235, USA b UniÕersity of Iowa, 108 PBAB, Iowa City, IA 52242, USA Received 1 October 1996; accepted 1 February 1998 Abstract Using a sample of 986 convertible bond issuers of U.S. operating companies during 1975 1990, we document poor stock and operating performance in the years following the offering. The underperformance of stock returns cannot be explained by new issues activity Žrecent initial public offerings Ž IPOs. or seasoned equity offerings Ž SEOs.. or the level of the proceeds. Concurrent with the low subsequent stock returns, we document a rapid decline in the operating performance of the issuers following the offering. Profit margin and return on assets for the issuers are approximately halved in the four years after the convertible bond issue. q 1998 Elsevier Science B.V. All rights reserved. JEL classification: G14; G32 Keywords: Convertible bond issuance; Long-run stock performance; Operating performance 1. Introduction The negative announcement effect of convertible bond issues has been well documented. For example, Mikkelson and Partch Ž 1986. report that firms which announce a convertible bond offering experience a 2% decline in their stock price. ) Corresponding author. Tel.: q1-216-368-5970; fax: q1-216-368-4776; e-mail: inmoolee@pyrite.som.cwru.edu. 1 Tel.: q1-319-335-0882; fax: q1-319-335-3690; e-mail: tim-loughran@uiowa.edu. 0929-1199r98r$19.00 q 1998 Elsevier Science B.V. All rights reserved. Ž. PII S0929-1199 98 00007-8

186 ( ) I. Lee, T. LoughranrJournal of Corporate Finance 4 1998 185 207 Most explanations for this negative announcement effect cite the asymmetric information between managers and outside investors. Assuming that corporate managers have more information about the firm, managers who try to maximize the wealth of existing shareholders have an incentive to issue equity when the firm s shares are overvalued Ž i.e., Myers and Majluf, 1984.. Since the convertible bond has an equity like characteristic, the negative announcement effect has largely been interpreted to be consistent with an overvaluation explanation. That is, the market realizes that managers have an incentive to issue convertible bonds when the firm s shares are overvalued. The magnitude of the announcement effect is intermediate between that of stocks and bonds. Previous studies have focused on announcement period returns by assuming that the market is at least semi-strong form efficient Ž see Lewis et al., 1994.. However, recent evidence related to the long-run abnormal performance of initial public offerings Ž IPOs., seasoned equity offerings Ž SEOs., dividend initiationsromissions, and stock repurchases ŽLoughran and Ritter, 1995; Spiess and Affleck-Graves, 1995; Michaely et al., 1995; Ikenberry et al., 1995. casts doubt on the efficiency of the market. These studies show that the market price does not fully reflect the informational content of corporate events during the announcement period, but instead underreact. In light of these recent studies, it would be interesting to examine the long-term performance of convertible bond issuing firms rather than just focus on short-term announcement period returns. If the market tends to underreact to this corporate action, as it does to the actions listed above, negative abnormal long-term returns may be present. Using a sample of 986 convertible bond offerings by U.S. operating companies during 1975 1990, we find that convertible bond issuing firms significantly underperform two stock return benchmarks. These benchmarks are the New York and American Stock Exchange value-weighted index, and matching firms selected to adjust for size and book-to-market effects Žor size-and-industry if the issuer s book value is unavailable.. Our issuers have an average annual return over the subsequent five-year period of 8.6% compared to 12.5% for matching firms and 14.5% for the value-weighted index. This underperformance cannot be explained by new issue activity Ž recent IPOs or SEOs. or the level of the proceeds. This paper also demonstrates that our issuer sample experiences a rapid decline in operating performance following the offering. For example, the median issuer profit margin falls from 5.1% at the time of the offering to 2.8% four years following the convertible bond offering. The median return on assets is halved in the four years following the convertible bond issue. Our matching firms do not exhibit the same degree of operating performance decline as issuers. Our stock return evidence is consistent with a concurrent working paper by Spiess and Affleck-Graves Ž 1996., who find that both a sample of straight debt and convertible debt offerings underperform following the debt offering. Spiess and Affleck-Graves also adjust for size and book-to-market effects in measuring abnormal returns for their sample of 393 convertible bond offerings during

( ) I. Lee, T. LoughranrJournal of Corporate Finance 4 1998 185 207 187 1975 1989. Their paper does not examine the subsequent operating performance of issuers. The paper is organized as follows. Section 2 describes the data and summary statistics and Section 3 presents empirical results. Section 4 gives the results of statistical significance tests using a simulation methodology. The operating performance of issuers and matching firms is examined in Section 5. Section 6 provides a summary and the conclusions. 2. Data and summary statistics 2.1. ConÕertible bond data The convertible bond issue information was purchased from the Securities Data Company Ž SDC. New Issues database, which includes only publicly placed firm commitment offerings. From the original sample, we exclude the offerings by firms which are not on the daily University of Chicago Center for Research in Security Prices Ž CRSP. New York Stock Exchange Ž NYSE. ramerican Stock Exchange Ž Amex. or Nasdaq tapes as of the issuing date. American Depository Receipts Ž ADRs., real estate investment trusts Ž REITs., and closed-end funds are excluded from our sample. We also exclude unit offerings, shelf registrations, and exchangeable bond offerings. 2 A total of 986 convertible bond issues during 1975 1990 are included in our final sample. Our average issuer raised 30% of its market capitalization Ž stock price times shares outstanding. in the convertible debt offering. 2.2. Matching firms In addition to the CRSP NYSErAmex value-weighted index, we use a matching firm benchmark to calculate abnormal returns. For firms with available Compustat book equity values Ž data item 60. prior to the offering, we use size and book-to-market Ž BErME. matching firms. Otherwise, we use size-and-industry matching firms as a benchmark. Overall, 664 issuers are matched by size-and- BErME and 322 issuers are matched by size-and-industry. Only CRSP-listed Ž CRSP-and-Compustat-listed for size-and-berme matching firms., non-equity issuing operating firms Žlisted on the CRSP NYSErAmex and Nasdaq tapes for at least five years without any convertible bond or initial public offerings during the prior five-year period. are used in the pool of possible matching firms. To be consistent with the convertible bond issuer sample selection criteria, we exclude closed-end funds, REITs, and ADRs. 2 Exchangeable bonds are convertible into shares of a different company.

188 ( ) I. Lee, T. LoughranrJournal of Corporate Finance 4 1998 185 207 We use an implementable methodology to select matching firms. The following describes the size-and-berme matching firm selection procedure. First, 25 portfolios of firms are formed based on market capitalization and BErME at the end of each month for the period from December 1974 through November 1990. All CRSP-and-Compustat-listed non equity-issuing operating firms on the NYSE, Amex, and Nasdaq exchanges are assigned to their corresponding size and BErME quintiles using independent sorts. The cut-off points for size quintiles are based on the market capitalization at the end of each month using only NYSE and Amex companies on the CRSP tapes. The cut-off points for BErME quintiles are based on the book value of equity divided by the market value of equity at the end of each month, using all NYSE, Amex, and Nasdaq companies. The book value of a given fiscal year is not used until at least four months after the end of the fiscal year Že.g., firms with a December 31 fiscal year end begin using the new book value for calculations done on April 30.. At the time of issue, each issuing firm with available book equity information is matched with one nonissuing firm in the same size and BErME portfolio whose market capitalization is closest to that of the corresponding issuing firm. 3 The market capitalization of issuing firms is calculated as of the offering date. Whenever book values of issuers are not available, we select size-and-industry matching firms in the following manner. First, all CRSP-listed firms with the same three-digit Ž two or one-digit if no other firm is available. Standard Industrial Classification Ž SIC. codes are sorted by their market capitalization as of the last day of the month prior to the offering. 4 Among these sorted firms, the nonissuing firm with the market capitalization closest to that of the corresponding issuer is chosen as the matching firm. 2.3. Buy-and-hold returns Buy-and-hold returns are used to measure performance of issuing firms and matching firms. 5 The buy-and-hold returns are calculated by compounding daily 3 The matching procedure creates only a minor difference in BErME ratio values between our sample and their matching firms. For example, the mean BErME ratio for issuers and their matching firms in each of the three bond rating categories is: investment grade Ž0.60 for our sample compared to 0.62 for matching firms., noninvestment grade Ž 0.47 compared to 0.52., and non-rated Ž0.47 compared to 0.47.. The median BErME ratio for issuers and their matching firms in each of the three bond rating categories is: investment grade Ž 0.54 compared to 0.55., noninvestment grade Ž 0.37 compared to 0.38., and non-rated Ž 0.39 compared to 0.41.. 4 Only four firms need to be paired on the single digit SIC code basis. 5 Differences in buy-and-hold returns are used rather than cumulative abnormal returns Ž CARs. to measure abnormal performance. The use of buy-and-hold returns is desirable in that the return differences are obtained by an implementable investment strategy, even though buy-and-hold returns tend to have a highly skewed distribution. While the use of CARs has the advantage of easier statistical tests, it is hard to interpret the results, which assume monthly portfolio rebalancing with zero transaction costs, in a practical and meaningful way.

( ) I. Lee, T. LoughranrJournal of Corporate Finance 4 1998 185 207 189 returns over either 252 trading days per year or the number of trading days from the offering date until the delisting date, whichever is smaller. The same holding periods are used to calculate the returns of matching firms. For firms delisted prior to the five-year anniversary of the offering, the buy-and-hold returns stop for the issuer and the matching firm on the issuer s delisting date. If a matching firm is delisted before the five-year anniversary Žor the issuer s delisting date, whichever is earlier., the holding period return for the matching firm is calculated by splicing the next matching firm s return from the delisting date of the first matching firm. The next matching firm is the company in the same BErME quintile Žor in the same industry. with the second closest market capitalization as of the original market capitalization ranking. 3. Empirical results 3.1. AÕerage buy-and-hold returns The number of convertible bond offerings by cohort year is reported in Table 1. As with IPOs and SEOs, the pattern of convertible bond issuance roughly follows the level of the stock market. In the bearish market of the 1970s, few firms issued convertible bonds. Following the sharp stock market rise during the mid-1980s, hundreds of firms issued convertible bonds. The average return for the convertible bond sample in the year prior to the offering is 54.2%, compared to 23.2% for the NYSErAmex value-weighted index. For every cohort year in our sample, the prior one-year return for the issuers is greater than the prior one-year return for the value-weighted index. The average one-year prior return for the matching firms is 41.2%. 6 The sample of issuers, on average, had strong stock performance in the year prior to the bond issuance. It should be noted however, that the prior return for convertible bond issuers is substantially less than the prior returns for firms which conducted a seasoned equity offering. For example, Loughran and Ritter Ž 1995. report an average one-year raw prior return of 72% for their sample of 3702 SEOs during 1970 1990. The five-year buy-and-hold returns for the stock of the issuers and their matching firms are also reported in Table 1. The average five-year buy-and-hold return for the issuers is 47.1% compared to 77.5% for their matching firms showing underperformance of 30.4% over five years. The five-year buy-and-hold returns are even lower than the one-year returns prior to the offering. 6 There is a statistically significant difference between the prior returns of the sample and their matching firms.

Table 1 Number of convertible bond offerings and prior and subsequent stock returns by cohort year, 1975 1990 Cohort Number Means Wealth Investment grade year of issuers Prior year returns for Prior year returns for 5-year returns for 5-year returns for relative offeringsrtotal offerings convertible issuers Ž %. VW index Ž %. convertible issuers Ž %. matching firms Ž %. 1975 16 24.3 13.9 93.7 66.3 1.16 62.5% 1976 19 31.0 24.3 181.2 238.3 0.83 15.8% 1977 11 52.3 1.9 87.9 123.8 0.84 18.2% 1978 14 113.0 10.9 121.6 257.5 0.62 7.1% 1979 22 49.9 16.4 86.8 129.6 0.81 9.1% 1980 78 78.3 27.4 51.6 95.9 0.77 16.7% 1981 73 73.6 17.9 83.2 127.0 0.81 42.5% 1982 57 33.8 6.7 77.5 251.0 0.51 22.8% 1983 84 125.6 45.0 24.9 44.5 0.86 25.0% 1984 57 10.3 3.4 67.7 107.2 0.81 38.6% 1985 122 48.9 23.9 47.3 58.8 0.93 36.1% 1986 193 51.5 31.2 10.7 21.5 0.91 13.5% 1987 132 46.0 27.1 19.8 29.6 0.92 22.0% 1988 30 3.9 y6.4 84.1 85.6 0.99 23.3% 1989 50 37.5 26.6 34.6 23.2 1.09 26.0% 1990 28 26.2 7.5 62.7 112.5 0.77 35.7% Total 986 54.2 23.2 47.1 77.5 0.83 25.1% Convertible bond issuers Ž NYSE, Amex, and Nasdaq firms. must be on the CRSP tapes at the time of the offering to be included in the sample. No ADRs, REITs, or closed-end funds are included in the sample. The convertible bond issue information was purchased from the Securities Data Company. Prior year returns are calculated over the year prior to the offering. The NYSErAmex value-weighted index in the year prior to the offering had an average return of 23.2%. Matching firms are selected on the basis of size-and-berme Ž or size-and-industry if book value is unavailable.. The matching firms in the year prior to the offering had an average return of 41.2%. The wealth relatives are defined as the average gross stock return of the issuers divided by the average gross stock return for the matching firms Ž e.g., for 1975, 1.16s193.7r166.3.. Investment grade are bonds rated AAA to BBB- according to either the Moody s or Standard and Poor s classification. 190 I. Lee, T. LoughranrJournal of Corporate Finance 4 ( 1998 ) 185 207

( ) I. Lee, T. LoughranrJournal of Corporate Finance 4 1998 185 207 191 One of our metrics to measure abnormal returns is the wealth relative. Wealth relatives are defined as the average gross stock return of the issuers divided by the average gross return for the matching firms. Wealth relatives greater than one imply that issuers have higher returns than their matching firms, while wealth relatives less than one imply underperformance by the issuers compared to their matching firms. The wealth relative for our sample of issuers is 0.83. This implies that investors would receive 83 cents in terminal wealth for investing in the stock of convertible bond issuers for every dollar invested in the size-and-berme matching firms. Only two cohort years Ž 1975 and 1989. have wealth relatives greater than one. This result indicates that the poor performance of convertible bond issuers is not driven by a few poor years. Our wealth relative is slightly closer to one than the wealth relative for firms conducting seasoned equity offerings. For example, Spiess and Affleck-Graves Ž 1995. report a wealth relative of 0.79 for their sample of 1247 SEOs during 1975 1989. The last column of Table 1 provides information on the credit ratings of the convertible bonds. On average, 25% of our sample issues were rated as investment grade by either the Moody s or Standard and Poor s bond rating services. The relatively low percentage of investment grade offerings is consistent with Brennan and Schwartz Ž 1988., who argue that firms with difficulties estimating their risk are likely to issue convertible bonds because convertible bond prices are insensitive to changes in risk. The first table documented the poor stock performance of our sample of convertible bond issuers compared to their matching firms. To examine the pattern of equity underperformance in the five years after issuance, Table 2 reports the yearly returns for our sample compared to the matching firms Ž Panel A. and the NYSErAmex value-weighted index Ž Panel B.. The number of firms present each year declines over time due to delistings Ž i.e., mergers or bankruptcies.. In Panel A, the yearly raw returns for the issuers range from 6.6% Ž in year 4. compared to 10.3% in the first year following the bond offering. However, the size-and-berme Ž or size-and-industry if book value is unavailable. matching firm yearly returns are consistently higher than for the issuers in the first four years following the offering. The return differences between the two groups range from y1.3% Ž z-statistics y1.26. to y5.7% Ž z-statistic y2.97. in the fourth year following the bond offering. The z-statistics test the equality of distributions between the issuers and matching firms using the Wilcoxon matched-pairs signed-ranks test. The last column reports that the average annual returns for the issuers are 8.6% compared to 12.5% for the matching firms. Thus, on an annual basis, issuers underperform their matching firms by almost 4%. Panel B of Table 2 reports that the yearly return performance of issuers is even worse if the benchmark is the NYSErAmex value-weighted index. The return difference between issuers and the value-weighted index ranges from y4.0% Ž z-statistic y5.53. to y8.1% Ž z-statistic y8.17.. The negative yearly abnormal

192 ( ) I. Lee, T. LoughranrJournal of Corporate Finance 4 1998 185 207 Table 2 Percentage yearly returns for convertible bond issuers compared to the matching firms and the NYSErAmex value-weighted index, 1975 1990 Portfolio Year 1 Year 2 Year 3 Year 4 Year 5 Average annual returns Panel A: Bond issuer returns Õersus matching firms Bond issuers 10.3 8.1 10.1 6.6 8.0 8.6 Matching firms 13.9 12.1 15.0 12.3 9.3 12.5 Number of firms 986 964 906 852 785 Return difference y3.6 y4.0 y4.9 y5.7 y1.3 y3.9 Ž z-statistic. Ž y1.91. Ž y2.72. Ž y3.39. Ž y2.97. Ž y1.26. Panel B: Bond issuer returns Õersus NYSEr Amex Õalue-weighted index Bond issuers 10.3 8.1 10.1 6.6 8.0 8.6 VW index 14.3 13.6 16.2 14.7 13.5 14.5 Number of firms 986 964 906 852 785 Return difference y4.0 y5.5 y6.1 y8.1 y5.5 y5.9 Ž z-statistic. Ž y5.53. Ž y7.12. Ž y7.16. Ž y8.17. Ž y5.79. Convertible bond issuers must be on the CRSP tapes at the time of the offering to be included in the sample. No ADRs, REITs, or closed-end funds are included in the sample. The return benchmark in Panel A is matching firms that have been selected on the basis of size-and-berme Žor size-and-industry if book value is unavailable.. The CRSP NYSErAmex value-weighted index is the benchmark reported in Panel B. The last column reports the average annual returns for issuers and matching benchmark. The z-statistics test the equality of distributions between the issuers and index using the Wilcoxon matched-pairs signed-ranks test. returns are economically and statistically significant. The pattern of underperformance for the sample of convertible bond issuers is consistent over each year following the bond offering. The average annual return for the value-weighted benchmark is 14.5%, 5.9% more than issuer returns. Fig. 1 reports the yearly stock returns for the bond issuers versus the matching firms Ž Panel A. and the value-weighted NYSErAmex index Ž Panel B.. 3.2. Bond ratings and gross proceeds To further understand the level of underperformance by convertible bond issuers, we categorize offerings by the bond rating Žeither by Moody s or Standard and Poor s rating agencies. and the size of bond proceeds Žboth global and domestic proceeds in 1994 dollars.. Our motivation for these categorizations is the prior literature. Table 7 of Mikkelson and Partch Ž 1986. report that convertible bond announcements with high bond ratings Ž A and above. have negative announcements effects, whereas convertible bond announcements with low ratings Ž B and below. have essentially no announcement effects. In a recent paper, Jewell and Livingston Ž 1996. report that bond ratings have a strong impact upon the long-run stock returns of straight bond issuing firms.

( ) I. Lee, T. LoughranrJournal of Corporate Finance 4 1998 185 207 193 Fig. 1. Yearly percentage returns for 986 bond convertible issuers versus matching firms Ž Panel A. and the NYSErAmex value-weighted index Ž Panel B.. Table 3 reports returns categorized by bond rating Ž Panel A. and gross proceeds Ž Panel B.. Panel A shows that the issuing firms with investment grade credit ratings, as well as those non-investment grade or non-rated issuing firms, significantly underperform their matching firms. The wealth relatives across the bond

194 Table 3 Returns for issuers of convertible bond offerings categorized by bond rating and gross proceeds, 1975 1990 Panel A: Categorized by bond rating Bond rating Number 5-year returns for 5-year returns for Wealth of firms bond issuers Ž %. matching firms Ž %. relative Investment grade 247 71.8 88.5 0.91 Non-investment grade 566 40.4 73.8 0.81 Non-rated 173 33.9 73.9 0.77 Total 986 47.1 77.5 0.83 Panel B: Categorized by bond rating and gross proceeds Bond rating Gross proceeds below median offering Gross proceeds above median offering No. 5-year returns for 5-year returns for Wealth No. 5-year returns for 5-year returns for Wealth bond issuers Ž %. matching firms Ž %. relative bond issuers Ž %. matching firms Ž %. relative Investment grade 41 91.9 122.9 0.86 206 67.8 81.6 0.92 Non-investment grade 304 48.7 84.5 0.81 262 30.6 61.5 0.81 Non-rated 157 35.5 74.2 0.78 16 18.0 70.7 0.69 Total 502 48.1 84.4 0.80 484 46.0 70.4 0.86 Convertible bond issuers must be on the CRSP tapes at the time of the offering to be included in the sample. No ADRs, REITs, or closed-end funds are included in the sample. Matching firms are selected on the basis of size-and-berme Ž or size-and-industry if book value is unavailable.. Investment grade is AAA to BBB- and non-investment grade is BBq to C. Both Moody s and Standard and Poor s are the rating services for the bond offerings. Total proceeds are in 1994 dollars and include both global and domestic proceeds from the bond offering. The wealth relatives are defined as the average gross return of the issuers divided by the average gross return for the matching firms. The median bond proceeds are US$57.0 million. I. Lee, T. LoughranrJournal of Corporate Finance 4 ( 1998 ) 185 207

( ) I. Lee, T. LoughranrJournal of Corporate Finance 4 1998 185 207 195 ratings range from 0.91 to 0.77. In Section 4, we will directly test for statistical significance levels between the groups. When the sample of issuers is divided into two groups Žabove and below the. 7 median proceeds of US$57.0 million in Panel B, no apparent pattern emerges. For example, firms with gross proceeds below the median offering of US$57.0 million have five-year buy-and-hold returns of 48.1% compared to their matching firm returns of 84.4%. Bond issuers above the median have five-year buy-and-hold returns of 46.0% compared to 70.4% for their matching firms. Thus, the size of the proceeds measured in 1994 dollars appears to have no predictive power to explain the underperformance pattern of convertible bond issuers. 3.3. New issue actiõity Ritter Ž 1991., Loughran and Ritter Ž 1995., and Spiess and Affleck-Graves Ž 1995. report that firms which issue new equity directly to the public Žeither IPOs andror SEOs. have low subsequent long-term returns against various benchmarks. It is conceivable that the low returns reported for our sample of convertible bond offerings are simply being driven by firms which also issued new equity to the public. That is, there may be no independent convertible bond effect, adjusting for new equity issue activity. To examine the influence of new equity issue activity in our sample, we report stock returns on convertible bond issuers categorized by bond rating and new issue activity in Table 4. Firms that issued an SEO or IPO in the two years prior to the convertible bond issue are in the left-hand columns. Of our sample of 986 bond issuers, 33% had recently issued new equity. Only 18% of the investment grade issuers, which tend to be older and larger firms, had recently issued new equity compared to 39% of the bond issuers with a non-investment rating. Consistent with the previous research, firms which recently issued new equity had low subsequent returns. The mean five-year buy-and-hold return for convertible issuers with recent SEOs andror IPOs is only 29.0%, compared to 64.7% for their matching firms. However, bond issuers which did not have any new issue activity in the prior two years also had poor subsequent returns compared to their matching firms. The sample of 659 bond issuers without recent new issue activity had five-year returns of 56.1% compared to 83.9% for their matching firms. Clearly, part of the low returns on convertible bond issuers is a manifestation of confounding effects to new issue activity. Yet, adjusting for new issue activity, poor subsequent stock performance for our sample of convertible bond issuers is still present. The 7 Several firms have gross proceeds of exactly $57 million in 1994 dollars. This accounts for the unequal number of firms in the two groups.

196 Table 4 Returns for issuers of convertible bond offerings categorized by bond rating and new issue activity, 1975 1990 Bond rating Issued SEO andror IPO within the two years prior to bond offering Else No. 5-year returns for 5-year returns for Wealth No. 5-year 5-year Wealth bond issuers Ž %. matching firms Ž %. relative returns for returns for relative bond issuers matching firms Ž %. Ž %. Investment grade 44 34.9 106.4 0.65 203 79.8 84.6 0.97 Non-investment grade 218 35.4 65.0 0.82 348 43.4 79.4 0.80 Non-rated 65 3.8 35.4 0.77 108 52.1 97.0 0.77 Total 327 29.0 64.7 0.78 659 56.1 83.9 0.85 Convertible bond issuers must be on the CRSP tapes at the time of the offering to be included in the sample. No ADRs, REITs, or closed-end funds are included in the sample. Matching firms are selected on the basis of size-and-berme Ž or size-and-industry if book value is unavailable.. Firms which issued a SEO andror IPO to the public in two years prior to the convertible bond issue date are in the left-hand columns. The wealth relatives are defined as the average gross return of the issuers divided by the average gross return for the matching firms. Investment grade is AAA to BBB- and non-investment grade is BBq to C. Both Moody s and Standard and Poor s are the rating services for the bond offerings. I. Lee, T. LoughranrJournal of Corporate Finance 4 ( 1998 ) 185 207

( ) I. Lee, T. LoughranrJournal of Corporate Finance 4 1998 185 207 197 Section 4 statistically tests the differences in abnormal returns between convertible bond issuers and their matching firms using a simulation methodology. 4. Statistical tests using a simulation methodology Kothari and Warner Ž 1997. and Barber and Lyon Ž 1997. show that biased inferences can be drawn by the use of standard parametric tests in studies of long-horizon abnormal stock returns around firm-specific events. This is because the skewed distribution of long-horizon returns, the clustering of observations over time, and BErME and size effects pose problems for standard parametric significance tests. To tackle this problem, a nonparametric simulation test procedure, which is similar to those used by Ikenberry et al. Ž 1995. and Lee Ž 1997., is used in this section. 8 We test whether the abnormal stock performance of issuing firms Žmeasured relative to the NYSErAmex CRSP value-weighted index. is reliably different from the abnormal performance of other companies with similar size and BErME Ž or similar size and industry.. 9 First, for each issuing firm, we find companies in the same size and BErME quintiles Žor companies in the same industry when book equity information of the issuing firm is not available. and then sort these companies according to their market capitalization at the end of the calendar month before the corresponding issuing firm s offering date. Among the sorted firms, a maximum of 30 firms with market capitalization closest to the corresponding issuing firm s are chosen and used to form a benchmark portfolio. Consistent with the matching firm selection criteria, only CRSP-listed ŽCRSP-and- Compustat-listed for size-and-berme matching firms., non issuing operating firms Žlisted on the CRSP NYSErAmex and Nasdaq tapes for at least five years without any convertible bond or initial public offerings during the prior five-year period. are used in the benchmark portfolio. Second, we calculate the five-year Ž and three-year and one-year. buy-and-hold period returns of the firms in the same size-and-berme portfolio Žor in the same size-and-industry portfolio.. The matching firm buy-and-hold returns are calculated over the identical time period as for the bond issuer. 10 Third, for each 8 This method is similar to the Bootstrap method Ž see Noreen, 1989.. However, it is closer to the Monte Carlo simulation method in that in each trial, a sample is randomly selected from all firms in the population Ž i.e., all firms in the benchmark portfolio. rather than from the original bond issuers. 9 Using the same method, we are also testing whether the buy-and-hold return Ž BHR. of issuing firms is significantly different from the BHR of similar non-issuing firms. This is true because the abnormal return of an issuing firm and that of its corresponding matching firms are calculated by subtracting the same BHR of the CRSP value-weighted index from their BHRs. 10 If a company is delisted before the end of the five-year anniversary or the bond issuer s delisting day, whichever is earlier, we splice the NYSErAmex CRSP value-weighted return into the calculation of the return from the day after the delisting date.

198 ( ) I. Lee, T. LoughranrJournal of Corporate Finance 4 1998 185 207 Table 5 Statistical significance of abnormal returns for convertible bond issuers Bond rating Number of bond Issuer abnormal b Mean of trials P-value issuers return a Ž %. Ž %. Panel A: 5-year return All Firms 986 y34.5 y7.9 0.000 Investment grade 247 y16.6 y17.4 0.551 Non-investment grade 566 y37.8 y3.8 0.000 Non-rated 173 y49.3 y7.9 0.000 Panel B: 3-year return All firms 986 y17.1 y4.1 0.000 Investment grade 247 y5.3 y7.0 0.626 Non-investment grade 566 y18.6 y2.7 0.000 Non-rated 173 y28.8 y4.4 0.000 Panel C: 1-year return All firms 986 y4.0 y1.4 0.038 Investment grade 247 0.7 0.1 0.591 Non-investment grade 566 y4.2 y1.2 0.058 Non-rated 173 y10.0 y4.2 0.044 a Average AR for issuers Ži.e., issuer holding period return minus the CRSP value-weighted index holding period return.. b Mean of average AR out of 10,000 trials. c P-value from empirical distribution Ži.e., number of trials with mean abnormal return less than or equal to the issuer s meanr10,000.. This table reports the results of the nonparametric statistical test described in Section 4. For each convertible bond issuing firm, a maximum of 30 CRSP-listed non-issuing operating companies Ž matching pool. are selected based on book-to-market equity ratio and market capitalization Žor market capitalization and SIC codes when book equity information is not available.. In each trial, one company is randomly selected from the matching pool for each issuing firm. The abnormal return of that randomly selected company is calculated by subtracting the buy-and-hold return Ž BHR. of CRSP value-weighted index from its BHR. Finally, the mean abnormal return is calculated over randomly matched pairs in each trial. This procedure is repeated 10,000 times. c issuing firm, we randomly select one company from the same benchmark portfolio. We then calculate the abnormal return Ž AR. of that randomly selected firm by subtracting the NYSErAmex CRSP value-weighted index return from the firm s holding period return. In each trial, the average AR Ž TAR. is calculated over the randomly selected firms. We repeat this procedure 10,000 times, thus producing an empirical distribution of 10,000 TARs. Finally, we test whether the average issuing firm s AR Ž AR. is significantly different from the mean TAR from 10,000 trials using the P-value from the resulting empirical distribution: X Number of trials with TAR being less than or equal to the issuer s AR P-values 10,000

( ) I. Lee, T. LoughranrJournal of Corporate Finance 4 1998 185 207 199 where the issuer s AR is the average of the convertible bond issuing firm s abnormal return and TAR is the average AR of each trial. Table 5 summarizes the results of the testing procedure. Panels A, B, and C show that convertible bond issuing firms significantly underperform similarly Table 6 Statistical significance of abnormal returns for convertible bond issuers: new equity issue activity Bond rating Number of bond Issuer abnormal b Mean of trials c P-value issuers return a Ž %. Ž %. Panel A: 5-year return Issued SEO andror IPO within the two years prior to bond offerings All firms 327 y52.5 y9.3 0.000 Investment grade 44 y66.4 y33.1 0.050 Non-investment grade 218 y42.0 y4.5 0.000 Non-rated 65 y78.6 y9.2 0.000 Else All firms 659 y25.5 y7.2 0.000 Investment grade 203 y5.8 y14.1 0.795 Non-investment grade 348 y35.1 y3.5 0.000 Non-rated 108 y31.7 y6.8 0.045 Panel B: 1-year return Issued SEO andror IPO within the two years prior to bond offerings All firms 327 y8.5 y3.7 0.024 Investment grade 44 y8.7 y4.3 0.254 Non-investment grade 218 y7.6 y2.6 0.043 Non-rated 65 y11.3 y7.1 0.228 Else All firms 659 y1.8 y0.3 0.208 Investment grade 203 2.7 1.0 0.704 Non-investment grade 348 y2.1 y0.3 0.250 Non-rated 108 y9.2 y2.4 0.065 a Average AR for issuers Ži.e., issuer holding period return minus the CRSP value-weighted index holding period return.. b Mean of average AR out of 10,000 trials. c P-value from empirical distribution Ži.e., number of trials with mean abnormal return less than or equal to the issuer s meanr10,000.. This table reports the results of the nonparametric statistical test described in Section 4. For each convertible bond issuing firm, a maximum of 30 CRSP-listed non-issuing operating companies Ž matching pool. are selected based on book-to-market equity ratio and market capitalization Žor market capitalization and SIC codes when book equity information is not available.. In each trial, one company is randomly selected from the matching pool for each issuing firm. The abnormal return of that randomly selected company is calculated by subtracting the BHR of CRSP value-weighted index from its BHR. Finally, the mean abnormal return is calculated over randomly matched pairs in each trial. This procedure is repeated 10,000 times.

200 ( ) I. Lee, T. LoughranrJournal of Corporate Finance 4 1998 185 207 sized firms in the same BErME quintile Ž or in the same industry. over five-year, three-year, and one-year time horizons. Out of 10,000 trials, there are zero cases in which the average abnormal five-year return of randomly selected firms is lower than that of the convertible bond issuers in the sample. Notice that the mean of trials for all firms is y7.9%. This result indicates that firms with size-and-berme characteristics Ž or size-and-industry. similar to our issuing firms have lower returns than the value-weighted NYSErAmex index during our sample period. Yet, the average issuer abnormal return is y34.5% compared to the value-weighted index. One exception to the overall poor performance of convertible bond issuers is found in investment grade issuers. Although investment grade issuing firms have low returns compared to the NYSErAmex value-weighted index, they do not significantly underperform similarly sized firms in the same BErME quintile Žor in the same industry.. For example, the average investment grade issuer abnormal return for the five-year holding period is y16.6% compared to the value-weighted index. Yet, similar characteristic matching firms have abnormal returns of y17.4% compared to the same index. To test whether the underperformance of issuing firms is driven by those which issued equity within the two years prior to convertible bond offerings, we repeat the simulation test for two separate subsamples, one with recent equity issues and the other without recent equity issues. The results in Table 6 show that even the firms without recent equity issues statistically significantly underperform their Notes to Table 7: a Average difference of ARs Ži.e., issuer s holding period return minus CRSP value-weighted index s holding period return. between two groups of convertible bond issuing firms. b Mean of average DAR out of 10,000 trials. c P-value from empirical distribution Ži.e., number of trials with mean DAR less than or equal to the issuer s meanr10,000.. This table reports the results of the nonparametric statistical test with which we examine the statistical significance of the differences in the performance of two groups with different characteristics. For each convertible bond issuing firm, a maximum of 30 CRSP-listed non-issuing operating companies Ž matching pool. are selected based on book-to-market equity ratio and market capitalization Žor market capitalization and SIC codes when book equity information is not available.. In each trial, one company is randomly selected from the match pool for each issuer. The abnormal stock return of that randomly selected company is calculated by subtracting the BHR of the CRSP value-weighted index from its BHR. Next, the mean abnormal return of the first group is calculated over randomly matched pairs in the first group. The mean of the second group is similarly calculated. Finally, the difference between those two mean abnormal returns Ž DAR. is calculated. This procedure is repeated 10,000 times. Issues without recent equity issues are those without either an IPO or SEO during the two-year period before convertible bond issuing. Large issues represent those issues with gross proceeds greater than the median of US$57.0 million in 1994 purchasing power. Investment grade issues includes those with a S&P or Moody s credit rating of BBB- or higher.

( ) I. Lee, T. LoughranrJournal of Corporate Finance 4 1998 185 207 201 Table 7 Statistical significance of abnormal returns for convertible bond issuers: Different groups of convertible bond issuing firms Bond ratingrnew issue activity Number of bond a Issuer DAR b Mean of trials c P-value issuers Ž %. Panel A: 5-year return Issues without recent equity issues Õs. issues with recent equity issues All firms 659, 327 27.0 2.0 0.994 Investment grade 203, 44 60.5 18.8 0.971 Non-investment grade 348, 218 6.8 1.0 0.673 Non-rated 108, 65 46.9 1.8 0.967 Large issues Õs. small issues All firms 484, 502 y2.7 y1.7 0.463 Investment grade 206, 41 y19.1 y0.4 0.222 Non-investment grade 262, 304 y16.3 3.4 0.067 Non-rated 16, 157 y21.8 y2.9 0.342 InÕestment grade issues Õs. non-inõestmentrnon-rated issues All firms 247, 739 23.9 y12.6 0.999 Non-IPOrSEO 203, 456 28.5 y9.5 0.998 IPOrSEO 44, 283 y16.0 y27.5 0.713 Panel B: 1-year return Issues without recent equity issues Õs. issues with recent equity issues All firms 327, 659 6.7 3.4 0.859 Investment grade 44, 203 11.5 5.2 0.799 Non-investment Grade 218, 348 5.5 2.3 0.791 Non-rated 65, 108 2.0 4.7 0.356 Large issues Õs. small issues All firms 484, 502 y1.5 2.1 0.109 Investment grade 206, 41 y5.4 3.4 0.136 Non-investment grade 262, 304 y6.4 1.4 0.025 Non-rated 16, 157 y7.3 y6.6 0.490 InÕestment grade issues Õs. non-inõestmentrnon-rated issues All firms 247, 739 6.2 1.9 0.893 Non-IPOrSEO 203, 456 6.5 1.9 0.871 IPOrSEO 44, 283 y0.3 y0.7 0.540 benchmarks in the long-run. 11 This indicates that the underperformance of convertible bond issuing firms is independent of equity issuing firms. In addition, Table 6 shows that the investment grade issuers do not underperform only if they are not recent equity issuers. 11 We also examined the three-year abnormal returns but do not report the results since they are similar to the five-year results.

202 ( ) I. Lee, T. LoughranrJournal of Corporate Finance 4 1998 185 207 To test for differences in abnormal returns of convertible bond issuers with different characteristics, we use the following procedure. First, we measure a DAR, which is the difference between the average AR of two different groups of convertible bond issuers. Second, to estimate the average DAR of those firms in the same size-and-berme portfolios Ž or in the same size-and-industry portfolios. as the bond issuing firms, we follow a procedure similar to that used above. For each firm in the first group of convertible bond issuers, one company is randomly selected from the benchmark portfolio. The AR of that company is calculated by subtracting the return of the NYSErAmex CRSP value-weighted index from the issuer s return. The average AR is then calculated over the randomly selected firms in this group for each trial. The average AR of the second group is similarly calculated. The difference between these two average ARs is the DAR of each trial. The mean DAR out of 10,000 trials is reported in the fourth column Žmean of trials. of Table 7. Table 7 shows that the long-run abnormal performance of convertible bond issuers without recent equity issues is statistically significantly better than those issuers with recent equity issues even though non equity issuers also significantly underperform their benchmarks. It also shows that in the long-run, investment grade issuers significantly outperform non-investment grade issuers but this result does not hold for those issuers with recent equity issues. Among non-investment grade issuers, both in the long-run and in the short-run, issuers with gross proceeds Table 8 Median profit margin and return on assets for convertible bond issuers and their matching firms in the years surrounding the bond offering, 1975 1990 Sample Fiscal year relative to offering 0 to q4 change y2 y1 0 q1 q2 q3 q4 Panel A: Median profit margin Bond issuers 5.1% 5.1% 5.1% 4.0% 3.4% 3.5% 2.8% y40.5% Matching firms 5.7% 5.5% 5.5% 5.2% 5.1% 4.8% 4.8% y23.7% z-statistic y2.89 y2.88 y3.52 y5.55 y4.93 y5.63 y6.15 y3.42 Panel B: Median return on assets Bond issuers 5.2% 5.0% 4.3% 3.3% 2.8% 2.9% 2.2% y41.5% Matching firms 6.4% 6.0% 5.5% 5.3% 4.7% 4.8% 4.5% y26.3% z-statistic y3.95 y4.45 y6.40 y7.51 y6.76 y7.21 y7.15 y3.56 Convertible bond issuers must be on the CRSP tapes at the time of the offering to be included in the sample. No ADRs, REITs, or closed-end funds are included in the sample. Matching firms are selected on the basis of size-and-berme Ž or size-and-industry if book value is unavailable.. Profit margin is defined as net income before extraordinary items Ž Compustat data item 18. divided by sales Ždata item 12.. Return on assets is defined as net income before extraordinary items Ž data item 18. divided by total assets Ž data item 6.. Year 0 is the fiscal year of the convertible bond offering. The last column reports the median change from year 0 to year q4 for those firms present in both years 0 and q4. The z-statistics test the equality of distributions between the issuers and matching firms using the Wilcoxon matched-pairs signed-ranks test.

( ) I. Lee, T. LoughranrJournal of Corporate Finance 4 1998 185 207 203 greater than the median significantly underperform those issuers with gross proceeds less than the median after controlling for size and BErME Ž or industry. effects. 5. Operating performance of issuers and matching firms This section examines the operating performance of issuers and their matching firms to determine whether the low subsequent stock returns for the convertible Ž. Ž. Fig. 2. Median Profit Margin Panel A and Return on Assets Panel B for sample of 986 bond convertible issuers and their matching firms in the years surrounding the bond offering.

204 ( ) I. Lee, T. LoughranrJournal of Corporate Finance 4 1998 185 207 bond issuers are linked to changes in profitability levels. Only firms listed on both the CRSP and Compustat tapes are included in this section. Following the conventional operating performance methodology, Table 8 and Fig. 2 report the median profit margin and median return on assets Ž ROA. for the sample of issuers and their matching firms in the two fiscal years before the offering and the four fiscal years following the offering. Profit margin is defined as net income before extraordinary items Ž Compustat data item 18. divided by sales Ž data item 12.. Return on assets is defined as net income before extraordinary items Ž data item 18. divided by total assets Ž data item 6.. Year 0 is the fiscal year of the convertible bond offering. No requirement is imposed on the length of Compustat availability for either issuers or their matching firms. The median issuer operating performance experiences a sharp decline following the offering. For example, in Panel A, the median profit margin for the issuers declines from 5.1% at the time of the offering to 2.8% four years later. Although the matching firms exhibit a general decline in profit margin Ž5.5% in year 0 to 4.8% in year q4., the operating performance decline is much worse for issuers. The general decline in operating performance by the matching firms is consistent with evidence of Table 3 of Barber and Lyon Ž 1996. on declining median operating ratios during our sample period. The median change in profit margin from the offering to four years later is y40.5% for the issuers compared to a median of y23.7% for the sample of matching firms. Interestingly, the convertible bond issuers do not experience an improvement in operating performance prior to the offering as has been documented for SEOs Žsee McLaughlin et al., 1996 and Loughran and Ritter, 1997.. The operating performance of issuers is flat in the years before the offering Žmedian profit margin is 5.1% for both years y2 and y1.. If the operating performance metric is ROA, the same pattern exists. Panel B reports that the median ROA of the issuers falls from 4.3% at the offering to 2.2% four years later. The matching firms experience a less rapid decline. The median year 0 to year q4 change in ROA for issuers is y41.5% compared to y26.3% for the matching firms. Thus, the issuance of a convertible bond is often followed by poor subsequent operating performance by the issuers. 6. Conclusion Our paper finds that in the long-run convertible bond issuing firms significantly underperform similarly sized firms in the same BErME quintile Žor in the same industry. and the value-weighted NYSErAmex index. The issuers underperform, on an annual basis, matching firms by 3.9% and the value-weighted index by 5.9%. Concurrent with the low returns, issuing firms experience a decline in operating performance after the convertible bond offering. This evidence appears to be consistent with firms selling convertible bonds when their stock is overval-

( ) I. Lee, T. LoughranrJournal of Corporate Finance 4 1998 185 207 205 ued. 12 It is puzzling why the market does not fully price this systematic post-issuance performance decline upon the offering announcement. One possible explanation is that firms raise a large amount of capital Žon average 30% of the market capitalization of equity in our sample. after experiencing a high prior year return. However, it appears that they are not able to find positive net present value projects to invest in. In other words, it is possible that the market underestimates a possible increase in free cash flow problems after issuing. This would explain both the low stock returns and poor operating performance after issuing. Jung et al. Ž 1996., McLaughlin et al. Ž 1996., and Lee Ž 1997. use a similar explanation for the poor performance of SEOs. The following question then arises: if managers are trying to take advantage of overvalued equity, why not just issue straight equity to the public? One answer to this question is that many firms in our sample do issue straight equity around the debt issuance. Over 30% of our convertible bond issuers had either an IPO or SEO in the two years prior to the debt offering. Another equity issue in close proximity to the first might arouse market suspicions and hinder the ability to sell overvalued securities. A second possibility is that firms may issue convertible debt instead of straight equity for tax considerations. Managers may believe that their firm is overvalued, yet still issue a convertible bond to lower their taxes through the interest deductibility of debt. This way, the issuing company also realizes the benefits from overvalued equity since the interest expenses would be less due to overvalued conversion options. Related to the evidence on managers valuation of their firms before issuing, Karpoff and Lee Ž 1991. and Kahle Ž 1997. show that insiders of convertible bond issuing firms sell their shares significantly more before convertible bond issues. This fact indicates that managers might have known that their shares were overvalued before the convertible bond issue. However, we cannot exclude the possibility of management s overoptimism. The significant increase of insider sales could have been driven merely by high pre-issuance prior returns. Moreover, Lee Ž 1997. shows that primary seasoned equity issuing firms where top executives purchased shares before issuance significantly underperform their matching firms as much as those firms where top executives sold shares beforehand. Lee argues that a significant portion of SEO firms appear to underestimate increases in free cash flow problems after new equity issues and do not knowingly sell overvalued equity. In summary, we document that convertible bond issuers significantly underperform their stock benchmarks in the long-run. This underperformance cannot be 12 However, it is not consistent with the survey results Ž Brigham, 1966; Hoffmeister, 1977. stating that managers decide to issue convertible bonds to delay the equity issue for a higher price in the future. In a more recent survey study, Billingsley and Smith Ž 1996. show that managers rely less on convertible debt as delayed equity financing Ž see Stein, 1992..