Convertible Exchangeable Preferred Stock

Convertible exchangeable preferred stock includes an option for the issuer to exchange the preferred for convertible bonds with identical pre-tax cash flows and conversion terms. In other respects this innovative corporate security is identical to traditional convertible preferred stock. The exchange feature provides the issuer with a potentially valuable option to swap a non-tax-deductible expense for a tax-deductible one. The exercise of the option imposes a cost on institutional investors, but even with the option fully priced, the innovative security should dominate the tradtional one as a capital raising vehicle. Thus, it is something of a puzzle that offerings of both security types persist for 15 years. I argue that firms expecting to force conversion quickly place a lower value on the tax shield obtainable by the exchange provision, and hence issue conventional convertible preferred to avoid pooling with lower-quality issuers. Thus, an offering of convertible exchangeable preferred stock should be a more negative signal than the traditional variety. Empirical evidence supports the hypothesis. The common stock price reactions to announcements of convertible exchangeable preferred stock average around –2% and are highly statistically significant. Reactions to convertible preferred stock announcements also are negative, but about half as large and less significant. Negative abnormal returns around the issuance date also are larger in the convertible exchangeable preferred sample. Cross- sectional regressions show that announcement and issuance abnormal returns depend on the use of the exchange option, whether the proceeds are used to refund existing convertibles, pre-offer financial leverage, growth opportunities and growth-related information asymmetry. Even firms with the most profitable growth opportunities experience negative abnormal returns around announcement and issuance, contradicting theories that predict positive information from equity- linked security offerings.