Signaling with Convertible Debt in High-Risk Industries

This paper analyzes how convertible debt is used in a high-risk, emerging industry setting. We argue that there is a lifecycle component to the design and market impact of convertible debt securities. Contrary to prior cross-industry research findings, we show that convertible debt in the renewable energy industry tends to have a debt-like structure, and its issue is associated with strongly nega¬tive announce¬ment returns. We further show that convertible issuers face high adverse selection costs, which they attempt to mitigate by sending signals about firm quality. However, these signals tend to fail because the market anticipates this behavior, and perceives convertible issuers as being priced out of the equity markets. Firm and industry characteristics support this view, because financial distress indicators suggest the use of more equity-like financing instruments