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Convertible Bond Underpricing: Renegotiable Covenants, Seasoning, and Convergence

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  • Alex W. H. Chan

    (School of Economics and Finance, The University of Hong Kong, Hong Kong)

  • Nai-fu Chen

    (The Paul Merage School of Business, University of California, Irvine, California 92697)

Abstract

We investigate the long-standing puzzle on the underpricings of convertible bonds. We hypothesize that the observed underpricing is induced by the possibility that a convertible bond might renegotiate on some of its covenants, e.g., an imbedded put option in financial difficulties. Consistent with our hypothesis, we find that the initial underpricing is larger for lower rated bonds. The underpricing worsens if the issuer experiences subsequent financial difficulties. However, conditional on no rating downgrades, our main empirical result shows that convertible bond prices do converge to their theoretical prices within two years. This seasoning period is shorter for higher rated convertible bonds.

Suggested Citation

  • Alex W. H. Chan & Nai-fu Chen, 2007. "Convertible Bond Underpricing: Renegotiable Covenants, Seasoning, and Convergence," Management Science, INFORMS, vol. 53(11), pages 1793-1814, November.
    • Handle: RePEc:inm:ormnsc:v:53:y:2007:i:11:p:1793-1814
    DOI: 10.1287/mnsc.1070.0722
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    References listed on IDEAS

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    3. Bruce D. Grundy & Patrick Verwijmeren, 2012. "Dividend-Protected Convertible Bonds and the Disappearance," Tinbergen Institute Discussion Papers 12-060/2/DSF37, Tinbergen Institute.
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    6. Duca, Eric & Dutordoir, Marie & Veld, Chris & Verwijmeren, Patrick, 2012. "Why are convertible bond announcements associated with increasingly negative issuer stock returns? An arbitrage-based explanation," Journal of Banking & Finance, Elsevier, vol. 36(11), pages 2884-2899.
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    11. Marle, Mats van & Verwijmeren, Patrick, 2017. "The long and the short of convertible arbitrage: An empirical examination of arbitrageurs’ holding periods," Journal of Empirical Finance, Elsevier, vol. 44(C), pages 237-249.
    12. Agarwal, Vikas & Fung, William H. & Loon, Yee Cheng & Naik, Narayan Y., 2011. "Risk and return in convertible arbitrage: Evidence from the convertible bond market," Journal of Empirical Finance, Elsevier, vol. 18(2), pages 175-194, March.
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    15. Heather Tookes & Brian Henderson, 2010. "Do Investment Banks' Relationships with Investors Impact Pricing? The Case of Convertible Bond Issues," Yale School of Management Working Papers amz2667, Yale School of Management.
    16. Darwin Choi & Mila Getmansky & Brian Henderson & Heather Tookes, 2009. "Convertible Bond Arbitrageurs as Suppliers of Capital," Yale School of Management Working Papers amz2365, Yale School of Management, revised 08 Dec 2009.
    17. Grundy, Bruce D. & Verwijmeren, Patrick & Yang, Antti, 2024. "Intermediary frictions and convertible bond pricing," Journal of Financial Intermediation, Elsevier, vol. 58(C).
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    20. Dutordoir, Marie & Pappas, Kostas & Xu, Alice Liang & Zeng, Cheng (Colin), 2023. "Covenants in convertible bonds: Boon or boilerplate?," Journal of Corporate Finance, Elsevier, vol. 80(C).

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