Bridge over ocean
1 April 2017 CFA Institute Journal Review

Short-Selling Pressure and Last-Resort Debt Finance: Evidence from 144(a) High-Yield Risk-Adjusted Debt (Digest Summary)

  1. Marc L. Ross, CFA

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 traded debt.
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.

Abstractor’s Viewpoint

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.

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