3. Reputation Effects on Convertible Bond Call Policies
3.3 Main Reputation Effects and Empirical Evidence
According to the analyses from the equilibria of the convertible bond calling game, we propose three information effects in the decision to call the convertible bonds. First, as stated in Proposition 3.1, the performance of the project in the 2nd period influences the firm’s value. Future success with a non-calling policy adds a reputation value to the firm, which is regarded as the feedback reputation effect.
Second, as stated in Proposition 3.2, the firm’s reputation influences the firm’s value.
Past success with a non-calling action adds a reputation value to the firm. This is regarded as the direct reputation effect. Third, combining Proposition 3.1 and Proposition 3.2, the firm conveys a signal of good management quality by not calling its convertibles. On the contrary, calling will signal the firm’s poor performance in the future and is regarded as the signaling effect.
3.3.1 Feedback Reputation Effect
In Proposition 3.1 as long as the reputation effect dominates the dilution effect, the firm with good management quality will not call the convertibles - that is, if the investors believe that the reputation value obtained from future success exceeds the dilution cost due to the voluntary conversion at time 2, then firms should wait until time 2 instead of making a conversion-forcing call at time 1. However, those that make a conversion-forcing call must perceive a failure in the future. A conversion-forcing call in advance can prevent a failed firm from repaying at time 2.
Hence, we find that a type-B firm calls the convertible bond.
On the other side, those that will succeed at time 2 will wait for the voluntary conversion. Since these firms that will succeed are more likely to be perceived as type-G firms, the future success (good reputation) adds value to firms with good management quality. Thus, a type-G firm will not make a call on the convertibles.
We call this the feedback reputation effect.
The prediction is consistent with the empirical study by Ofer and Natarajan (1987). Except for the stock price reaction, they directly tested the firm’s economic performance and saw a significant decline in the firm’s earnings after the call.
Further in their study, they identified that the call was due to the expectation of a future decline. Hence, if the firm anticipates a success in the future, then it chooses not to call so as to obtain the reputation value in addition to its original firm value.
3.3.2 Direct Reputation Effect
As in Proposition 3.2, assuming that the past reputation dominates, the investors believe that those succeeding in the 1st period are more likely to be type-G firms, no matter whether they will succeed or not in the 2nd period. In this case, those firms that have had good reputations will obtain a reputation value and choose not to call the convertibles. We call this the direct reputation effect. On the contrary, those having had bad reputations are less likely to be perceived as type-G firms.
Accordingly, a decrease in the firm’s value forces a type-B firm with bad reputation to make a conversion-forcing call at time 1.
The essence of this reputation model is to identify that it is indeed a reputation-building activity not to call back the convertible bonds. As emphasized by Wilson (1985), the key ingredient of the reputation effects is that a player can adopt actions that sustain the probability assessments made by other participants which yield long-term consequences. In our application model of the convertible bond calling game, if a firm continues to establish its reputation by not calling its convertible bonds, then it builds up its long-term reputation to be a firm of good management quality and hence generates trust in the firm by bondholders and stockholders.
This gives another reason for the discrepancies between the short-term price
reversal and the long-run underperformance of the calling firm’s common stock.
Contrary to the positive short-run stock price performance found by Byrd and Moore (1996) and Ederington and Goh (2001), Datta et al. (2003) evaluated the long-term effect on the common stock price after the call and found that over a five-year post-call period, the common stocks of calling firms underperform their benchmarks.
In their view, they agreed with Daniel et al. (1998) by stating that the relatively short post-call time horizon examined by previous studies, like Byre and Moore (1996) or Ederington and Goh (2001), is insufficient to draw reliable conclusions regarding the information conveyed by conversion-forcing bond calls. We further suggest that it is the accumulated rent generated from the firm’s reputation that is being neglected when evaluating in the short run - that is, when the firms play in an economy with infinite generations, they accumulate their reputation rents by not calling the convertible bonds in the long run.
3.3.3 Signaling Effect
Based on Propositions 3.1 and 3.2, we conclude a signaling effect as proposed by Harris and Raviv (1985). Harris and Raviv (1985) looked at a firm’s decision as an informational problem and proposed a signaling theory stating that a decision to call is perceived by the market as a signal of unfavorable prospects. Thus, the manager calls after receiving a “bad”message and never calls after receiving a “good”
message.
The separating equilibrium obtained in the reputation model implies that a type-G firm will not call the convertible bonds. A type-G firm is also more likely to succeed in time 2. Thus, not calling conveys good news for the firm’s future. On the other side, a type-B firm will choose to make a conversion-forcing call and a type-B firm is more likely to fail in the future. Hence, calling signals a bad future for the firm’s project.
Empirical studies by Ofer and Natarajan (1987) and Datta et al. (2003) confirm the signaling theory. Ofer and Natarajan (1987) found that a firm’s earnings decline significantly after convertible calls. Datta et al. (2003) evaluated data over a five-year post-call period, seeing that the common stocks of calling firms underperform their benchmarks. Both prove that a conversion forcing call conveys
bad news.