Why do publicly traded nonfinancial firms issue convertible high-yield Rule 144(a) debt,
given financial markets’ negative reaction to announcements of such issuances? Rule
144(a) borrowers tend to have weak balance sheets, resorting to such debt as a matter of
last resort. Convertible bond arbitrageurs’ short sales of these bonds are behind
the negative equity market response.
How Is This Research Useful to Practitioners?
Created in 1990, SEC Rule 144(a) sought to correct the flaws in the traditional private
placement market, wherein borrowers would “place” money directly with investors
(lenders). The rule was designed to lessen the disclosures and costs that are part of the
registration process. It aims to help avoid more restrictive borrowing covenants that are
normally part of publicly issued bonds and to speed up the time to issue debt securities.
The SEC rule allows so-called 144(a) securities to be registered as publicly traded issues
60 days after issuance, affording investors both liquidity and transparency. From 2002 to
2011, 144(a) issues were a greater proportion of high-yield debt issuance than publicly
Looking at a large sample of Rule 144(a) debt issues in the United States over a 21-year
period, the authors examine why an issuer would choose this type of bond in the face of
markets’ negative perception of them. Indeed, many of these sorts of bonds are
convertible into shares of common stock. Accordingly, many hedge funds that use convertible
bond arbitrage strategies buy 144(a) bonds and sell short the borrower’s underlying
shares to capture an arbitrage profit. Rule 144(a) issuers are thus likely to experience a
negative reaction from equity markets.
Negative public perception of these issues raises the question of why firms would use them,
given the bonds’ tendency to reduce shareholders’ wealth. Firms with a
distressed balance sheet or questionable creditworthiness appear more likely than other
firms to tap the 144(a) market in a last-ditch effort to satisfy urgent near-term
operational financing needs rather than as a way to secure a longer-term investment.
Fixed-income analysts who specialize in high-yield issues will glean useful insights into
issuers’ motivations for using this type of debt. The authors’ work will
inform market strategists and portfolio managers, whose decisions rest importantly on the
study of financial markets.
How Did the Authors Conduct This Research?
The authors consult the relevant literature on the 144(a) debt market to inform their
research. They examine a cross section of US-listed firms from 1990 to 2011. The Fixed
Investment Securities Database is the source of the Rule 144(a) debt sample. It is also the
source of non-Rule 144(a) debt samples, along with the SDC Platinum Database for private
loan samples. The analysis excludes public utilities and financial firms, which are both
subject to additional regulation. Daily stock return data come from the CRSP database, along
with accounting and cash flow numbers from the CRSP/Compustat Merged database. Winnowing
produces a final debt sample comprising 1,721 144(a) debt issues, 3,298 public debt issues,
and 9,485 bank loans; 529 of the 1,721 144(a) issues are convertible bonds.
To gauge whether a firm’s announcement of 144(a) debt issuance adversely affects its
stock returns, the authors conduct an event study. They also perform related analyses to
determine whether convertible bond arbitrageurs’ actions negatively affect equity
returns, estimating a regression model to determine the degree of association between
negative cumulative abnormal returns and these traders’ activities. The
authors’ testing controls for sample selection bias.
Test results confirm that firms more likely to issue 144(a) convertible debt tend to be
smaller, less profitable, and of lower creditworthiness. Accordingly, the offering yield on
their borrowings is roughly 1.36% higher than on non-144(a) debt, suggesting that 144(a)
debt is a type of high-yield bond. The authors’ analysis confirms that convertible
144(a) announcements have a wealth-destroying effect, causing significant negative
cumulative abnormal returns on the issuer’s stock price because of the short selling
by arbitrageurs drawn to these types of issues. A delta-neutral strategy can be used that
computes the number of shares to sell short in order to mitigate any effect on the bond
price. Once the immediate hedging activity subsides, the stock price tends to recover. The
average share price declines 3.53% relative to the market near the announcement date but
recovers 2.35% in the subsequent month.
The authors’ probit regression analysis substantiates 144(a) debt financing as a
last resort for firms in financial difficulty that lack other options. Such firms would have
below-investment-grade debt ratings and would use such debt to manage near-term, day-to-day
operational exigencies (for example, accounts payable and accrued liabilities). A series of
regressions that match sources of funds to uses of proceeds validates this observation.
The authors’ analysis of why firms use a seemingly wealth-reducing form of debt is
an important contribution to the literature on behavioral finance in corporate finance
departments. Rule 144(a) convertible debt is a type of high-yield bond subject to the whims
of arbitrageurs looking to profit from financially distressed firms that have little choice
but to use it. The authors are the first not only to posit the demand-side explanation of
last-resort debt financing but also to explore the 144(a) market from an equity perspective.
Their contribution is meaningful for both strategists and behavioral economists.