CONVERTIBLE SECURITIES AND HETEROGENEITY OF INVESTOR BELIEFS

• Author: An Yan,Jie Jiao
• Date: 01 June 2015
• Published date: 01 June 2015
• DOI: http://doi.org/10.1111/jfir.12059

CONVERTIBLE SECURITIES AND HETEROGENEITY OF

INVESTOR BELIEFS

Jie Jiao

Tsinghua University

An Yan

Fordham University

Abstract

We conjecture that convertibles can better attract investors with different beliefs about a

firm’s future cash flows compared to straight bonds and stocks. Our empirical findings

are consistent with this conjecture. We find that a firm is more likely to issue convertibles

rather than seasoned stocks and straight bonds in the public markets when investors’

beliefs are more heterogeneous. The positive effect of heterogeneous beliefs on the

relative likelihood of convertibles is greater when investors are more optimistic. Overall,

our findings provide a novel rationale based on investors’heterogeneous beliefs for the

use of convertibles in corporate external financing decisions.

JEL Classification: G32, G34

I. Introduction

Investors have heterogeneous prior beliefs on a firm’s value. The relation between

heterogeneity of investor beliefs and security values has received a great deal of attention

in the finance literature. This research dates back to Miller (1977) and subsequently

Harrison and Kreps (1978), Mayshar (1983), and Morris (1996). Miller argues that when

investors with heterogeneous beliefs are subject to short-sale constraints, stock prices

reflect the opinion of optimistic investors and sell at a premium over fundamental values.

Recently, many studies have empirically tested Miller’s predictions. For example, Chen,

Hong, and Stein (2002) and Diether, Malloy, and Scherbina (2002) focus on the effect of

heterogeneity of investor beliefs on future stock returns. They find evidence supporting

the predictions of Miller’s model (see also Duffie, Garleanu, and Pedersen 2002;

Scheinkman and Xiong 2003; Hong, Scheinkman, and Xiong 2006).

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However, most empirical research in this literature examines the effect of

investors’heterogeneous beliefs on stock value. Little empirical research has studied the

effect of heterogeneous beliefs on the value of other types of securities. Also, it is not well

understood how heterogeneity of investor beliefs affects a firm’s corporate financing

We would like to thank the JFR editors and two anonymous referees for their comments.

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In contrast, Diamond and Verrecchia (1987) predict unbiased stock price in the presence of heterogeneous

investor beliefs.

The Journal of Financial Research Vol. XXXVIII, No. 2 Pages 255–281 Summer 2015

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RAWLS COLLEGE OF BUSINESS, TEXAS TECH UNIVERSITY

PUBLISHED FOR THE SOUTHERN AND SOUTHWESTERN

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decisions among various securities. In this article, we address these questions by

focusing on convertible securities, an important type of security in corporate financing

decisions. We study how the heterogeneity of investor beliefs on a firm’s future cash

flows affects the firm’s incentive to issue convertible securities rather than straight bonds

and seasoned stocks.

We conjecture that convertibles attract investors with heterogeneous beliefs on a

firm’s future cash-flow distribution better than do straight bonds and seasoned stocks. In

the following, we discuss briefly the intuition behind this conjecture. We provide a more

complete discussion and develop our hypotheses more fully in Section II.

Consider Miller’s (1977) framework where investors have heterogeneous

beliefs and they are subject to short-sale constraints. Also consider two types of

heterogeneous investors who could invest in the firm’s securities. The first type prefers to

invest in equity based on their beliefs, and the second type prefers to invest in straight

bonds. In this case, the issuing firm could find it undesirable to issue both straight bonds

and stocks, as both securities appeal to only one type of investor. Unlike straight bonds

and stocks, convertible securities can help attract both types of investors with different

preferences. A convertible security is a hybrid comprising a debt component and a stock

component. It has different consequences from straight bonds and stocks because the

entire issuance is in the form of debt if the convertible is never converted, and the

entire issuance becomes common stock upon conversion. The stock component

helps the issuing firm attract the first type of investors who prefer to invest in equity. The

debt component helps the issuing firm attract the second type of investors who prefer

to invest in straight bonds. Thus, a convertible security has an advantage over straight

bonds and stocks in that it can attract investors who have different beliefs and thus

different investment preferences over stocks and straight bonds. This is our first

hypothesis.

In consideration of the above discussion, we hypothesize that the likelihood of a

convertible issuance rather than straight bond and stock issuances is higher when

heterogeneity of investor beliefs is higher. Furthermore, in Miller’s (1977) framework,

any securities issued by a firm are purchased by investors who are more optimistic than

other investors. Thus, the heterogeneous belief argument also predicts that the effect of

heterogeneity of investor beliefs on the relative likelihood of a convertible issuance is

greater when investors are more optimistic in the capital markets. This is our second

hypothesis.

We test our hypotheses using a sample of U.S. public offerings of convertibles,

straight bonds, and seasoned stocks. We use four proxies for heterogeneity of investor

beliefs. Our first proxy is analyst dispersion, based on the standard deviation of financial

analysts’forecasts on a firm’s one-year-ahead earnings. A higher level of analyst

dispersion indicates a higher level of heterogeneous investor beliefs (Diether, Malloy,

and Scherbina 2002). Our second proxy is stock trading turnover. An increase in

heterogeneity of investor beliefs is associated with an increase in trading turnover (see,

e.g., Harris and Raviv 1993; Hong and Stein 2003; Scheinkman and Xiong 2003). Our

third proxy is idiosyncratic volatility. A firm facing a higher level of heterogeneous

investor beliefs experiences greater idiosyncratic volatility (see, e.g., Diether, Malloy,

and Scherbina 2002; Boehme, Danielsen, and Sorescu 2006). Our final proxy is breadth

256 The Journal of Financial Research