A Study of the Causality Between Convertible Bond Prices and Stock Prices in Conversion‐price Reset Periods—Time‐series and Cross‐section Analyses

• Author: Tsun‐Siou Lee,Ma‐Ju Wang,Yun‐Wei Lin
• Published date: 01 June 2015
• Date: 01 June 2015
• DOI: http://doi.org/10.1111/ajfs.12096

A Study of the Causality Between

Convertible Bond Prices and Stock Prices in

Conversion-price Reset Periods—Time-series

and Cross-section Analyses

Ma-Ju Wang*

Department of Finance, National Kaohsiung First University of Science & Technology

Yun-Wei Lin

Research Department, Wider View Securities Investment Advisory Co., Ltd.

Tsun-Siou Lee

Department of Finance, National Taiwan University

Received 11 May 2014; Accepted 24 November 2014

Abstract

This study examines the causality between the returns of convertible bonds and stocks dur-

ing periods of conversion-price resets and general pre-reset in Taiwan. Profits, stock turnover,

and firm size affect the significance of causality. The empirical results indicate that the

returns of convertible bonds always lag behind the stock returns for general pre-reset periods.

However, for reset periods, the numbers of companies for which convertible bonds lead

ahead of the stock market increases. The causality reversal is based on uprising liquidity and

information transparency. These results provide evidence that various reset price mechanisms

affect financing market efficiency.

Keywords Convertible bond; Reset period; Causality; Reversal

JEL Classification: G10, G30, G32

1. Introduction

Convertible bonds (CB) are characterized by the issuance of equity securities (Stein,

1992). When underlying stock prices increase, the value of CBs also increase. In

Taiwan, CBs with zero coupon rates and low putable yields sell quickly upon issu-

ance, which indicates that the value of CBs is based on the prospects of companies

*Corresponding author: Ma-Ju Wang, Department of Finance, National Kaohsiung First Univer-

sity of Science & Technology,No. 1, UniversityRd., Yanchao District,Kaohsiung City 824,Taiwan.

Tel: +886-7-6011-000ext 4027, Fax: +886-7-6011-041, email:majuwang@nkfust.edu.tw.

Asia-Pacific Journal of Financial Studies (2015) 44, 447–474 doi:10.1111/ajfs.12096

©2015 Korean Securities Association 447

and that buyers have optimistic expectations regarding stock prices. Hence,

although the listing of CBs differs from the underlying stocks listed in Taiwan, the

correlation between the values of both factors is implied (Wang and Lin, 2011).

Price-reset clause mechanisms are rarely observed in the world’s financial mar-

kets, and the convertible market in Taiwan is a special case. This mechanism is

designed to reset conversion prices downward during conversion periods if the ori-

ginal conversion price is higher than the average market price before the agreed

upon reset day in the contract, which can enhance the opportunity for investors to

exercise conversion rights. This increase may improve the attractiveness of bonds to

investors, and it is helpful for companies in financing. Furthermore, the increase

can reduce the pressure of debt repayment for companies if investors convert suc-

cessfully, which has the benefit of adjusting conversion prices downward for compa-

nies. However, the increase would dilute profits and equity because the conversion

makes outstanding common stocks increase, which is disadvantageous to existing

shareholders. Conflicts between old and new shareholders of companies might

influence the correlation between the prices of CBs and stocks. From this perspec-

tive, investigating the relationship between the two market prices during conver-

sion-price reset periods is more critical than during general non-reset periods.

Are there any causality relationships with respect to leading and lagging between

stock returns and bonds returns? This topic is not new, but the literature reveals

only a few discussions of this matter. Goyenko and Ukhov (2009) establish a liquid-

ity linkage between stocks and Treasury bond markets. There is a lead-lag relation-

ship between the illiquidity of the two markets and bidirectional Granger causality.

The effect of stock illiquidity on bond illiquidity is consistent with flight-to-quality

or flight-to-liquidity episodes. Gebhardt et al. (2005) examine the interaction

between momentum in the returns of equities and corporate bonds. Significant evi-

dence suggests a momentum spillover from equities to the investment-grade corpo-

rate bonds of the same firm. Firms earning high (low) equity returns over the

previous year earn high (low) bond returns the following year. Past equity returns

are a better proxy of firm fundamentals than past bond returns (Hand et al., 1992;

Brennan et al., 1993; Kwan, 1996). However, bonds do not play an entirely passive

role. Butler and Wan (2010) documents that debt issuers have significantly higher

stock market liquidity than their size- and book-to-market-matched counterparts.

A causality relationship between the returns of CBs and stocks will be more pre-

valent because of the ability of CBs to be converted to stocks. Downing et al.

(2009) and Norden and Weber (2009) find that stock returns lead bond returns for

CBs in all rating classes. The corporate bond market is less informational and effi-

cient than the stock market, notwithstanding the recent improvements in bond

market transparency and associated reductions in corporate bond transaction costs

(Bessembinder et al., 2006; Edwards et al., 2007; Goldstein et al., 2007; Goyenko

and Ukhov, 2009). Because there are leading and lagging relationships between the

returns of the two markets, it is easy to attract investors to engage in arbitrage.

Choi et al. (2009) show that there is considerable evidence of arbitrage-induced

M.-J. Wang et al.

448 ©2015 Korean Securities Association