Agency Costs

Convertible bonds can resolve agency problems associated with raising money. In a previous chapter we showed that straight bonds are like risk-free bonds minus a put option on the assets of the firm. This creates an incentive for creditors to force the firm into low-risk activities. In contrast, holders of common stock have incentives to adopt high-risk projects. High-risk projects with negative NPV transfer wealth from bondholders to stockholders. If these conflicts cannot be resolved, the firm may be forced to pass up profitable investment opportunities. However, because convertible bonds have an equity component, less expropriation of wealth can occur when convertible debt is issued instead of straight debt.11 In other words, convertible bonds mitigate agency costs. One implication is that convertible bonds have less-restrictive debt covenants than do straight bonds in the real world. Casual empirical evidence seems to bear this out.

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