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Do Investor Demand and Market Timing Affect Convertible Debt Issuance Decisions by REITs?

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Abstract

The unique regulatory environment of REITs casts doubt on the traditional theoretical process by which REIT managers base their convertible debt issuance decisions on issuer condition and prospects. Anecdotal evidence shows that REITs may have catered to demand by investors, including a demand by convertible bond arbitrageurs when issuing convertible debt. This study examines the rationale behind convertible debt issuances by REITs, focusing on the possible impacts of investor demand and market timing. The results suggest that investor demand significantly affects convertible debt issuance decisions by REITs while certain unknown factors appear to have contributed to the sudden increase of convertible debt offerings in 2006 and 2007. REITs also time the market to conditions in the public debt market. The results only partially support the offered risk-shifting, risk-uncertainty, backdoor-equity, and sequential-financing hypotheses.

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Notes

  1. In the general stock market, convertible debt issues increased steadily from 91 issues in 1993 to 179 issues in 2002, reaching peaks of 211 issues and 265 issues in 1997 and 2001, respectively. Even during the financial crisis of 2007–2008, general firms raised nearly $118 billion through convertible debt issues.

  2. Real Estate Finance & Investment, Vol. XII, No. 34, Institutional Investor, Inc. (www.iirealestate.com)

  3. Empirical support for the “risk-shifting” hypothesis has focused on examining the abnormal stock returns around convertible debt offerings (Dann and Mikkelson 1984; Asquith and Mullins 1986; Eckbo 1986; Masulis and Korwar 1986; Mikkelson and Partch 1986; Smith 1986; Hansen and Crutchley 1990; and Pilotte 1992). For example, Dann and Mikkelson (1984) find that stock price responses to convertible debt offerings are fairly similar to those of straight debt offerings, implying that convertible debt can be viewed as a substitute for straight debt.

  4. Using a model which incorporates the Black-Scholes option pricing model, Brennan and Schwartz (1988) demonstrate that the value of convertible debt is relatively insensitive to the risk of the issuing company. When the riskiness of a firm increases, the value of the underlying bond decreases, but this reduction in value is compensated by an increase in the value of the conversion option (due to increased volatility).

  5. Note that, in the presence of adverse selection, issuing common equity is costly because of the low market valuation of a firm’s share prices vis-à-vis its future growth prospects.

  6. Empirical support for the “sequential-financing” hypothesis is provided by Asquith and Mullins (1991); Essig (1992); and Jen, Choi, and Lee (1997).

  7. Although Howe and Shilling (1988) and Ghosh et al. (1999, 2001) find a positive stock price reaction to debt offerings and a negative stock price reaction to REIT equity offerings, Francis et al. (2004) observe that the stock price reaction to REIT equity offerings is more favorable than the reaction to equity offerings by non-REIT corporations.

  8. The percentage of REITs with OptionMetrics option data among all REITs ranged from 10 % to 35 % over the sample period.

  9. The difference between the implied volatility and realized volatility may imply richness/cheapness of convertible debt with excess implied volatility, thus indicating that the convertible debt is overpriced. However, we use this variable as a measure of overall investor demand for options in a market, as Garleanu et al. (2009) showed, especially because the forward-looking nature of this implied volatility suggests the possibility of future market turmoil, leading to a greater demand for the downside protection that convertible debt offers compared to an underlying equity.

  10. We also tried a more direct measure of the expected volatility or the difference between the volatility after issuance and the volatility prior to issuance, assuming that specialized parties, such as convertible bond arbitrageurs, are supposed to have some foresight of returns and risks. We find that this variable does not significantly affect the choice of convertible debt over common equity (z = 1.02; p = 0.310) and over straight debt (z = 1.04; p = 0.297), implying that even these sophisticated investors may not have a superior ability to forecast future risk.

  11. We also use an alternative measure, dividing dividend by share price as a robustness check. We find that the alternative measure in an expected way also affects the choice of convertible debt over common equity (z = 2.86; p = 0.004) and over straight debt (z = 2.89; p = 0.004).

  12. Convertible debt enables investors to participate in a company’s stock price appreciation while providing some amount of downside protection against a decline in the underlying common stock share price.

  13. As with the expected volatility measure, we also apply the LPM measured over one quarter after issuance, assuming that convertible bond arbitrageurs do have some foresight of returns and risks. We find that this variable does not significantly affect the choice of convertible debt over common equity (z = −0.54; p = 0.588) and over straight debt (z = −0.66; p = 0.512), implying that even these sophisticated investors may not have any superior ability to forecast future risk.

  14. Note that both the investor demand variables of expected volatility and abnormal return and the market timing variables measure certain market conditions. We define investor demand variables as those that appear to affect mainly the behaviors of investors (for example, convertible bond arbitrage hedge funds) and define market timing variables as those that appear to affect mainly the behaviors of REIT issuers of convertible debt. We utilize the market variables of REITs in the sample instead of the aggregate market variables so as to capture the market conditions exposure for these REITs.

  15. Market-to-book ratio is used also as a measure for asymmetric information in the REIT literature (Hardin et al. 2009; Hardin et al., 2010). However, An et al. (2012) question the validity of market-to-book ratio as a measure of asymmetric information of REITs, and Feng et al. (2007) suggest that the market-to-book ratio of REITs is a valid measure for growth opportunity.

  16. An UPREIT or umbrella partnership real estate investment trust is a REIT that holds properties through an umbrella-limited partnership in which the REIT holds the general partnership interest.

  17. Harrison et al. (2011) report that the state of incorporation may affect firm value and agency conflicts.

  18. The full correlation matrix is available from the authors upon request.

  19. Spread is measured by the difference between coupon rate for the convertible debt and the yield of comparable government bond yield.

  20. We tested whether the independence of irrelevant alternatives (IIA) assumption is fulfilled following Freese and Long (2001). We use a multinomial logistic regression instead of a nested logistic model, as both Hausman and Small-Hsiao tests supported the IIA assumption.

  21. We also estimated models only with the variables suggested by traditional theories and REIT specific controls with and without year dummies. In such models, year dummy effects are even more significant and the addition of year dummies increase the R-square of the model to a greater extent.

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Acknowledgements

We would like to thank Michael J. Seiler who served as a discussant for our presentation at the NUS-MIT-Maastricht 2012 Real Estate Finance and Investment Symposium and provided us with the helpful suggestions on the earlier draft. We are also grateful for an anonymous reviewer and the Journal of Real Estate Finance and Economics editors, Piet Eichholtz, David M Geltner, and Seow Eng Ong for their constructive comments.

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Authors and Affiliations

  1. Department of Real Estate, National University of Singapore, 4 Architecture Drive, Singapore, 117566, Singapore

    Masaki Mori & Joseph T. L. Ooi

  2. Universiti Utara Malaysia, School of Economics, Finance and Banking, 06010, Sintok, Kedah, Malaysia

    Woei Chyuan Wong

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  1. Masaki Mori
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Correspondence to Masaki Mori.

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Mori, M., Ooi, J.T.L. & Wong, W.C. Do Investor Demand and Market Timing Affect Convertible Debt Issuance Decisions by REITs?. J Real Estate Finan Econ 49, 524–550 (2014). https://doi.org/10.1007/s11146-013-9443-y

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