International Review of Economics and Finance 9 2000 139–156
Self-selection and the effects of poison putcall covenants on the reoffering yields of corporate bonds
Khalil M. Torabzadeh
a,
, John Roufagalas
b
, Criss G. Woodruff
c
a
Faculty of Management, The University of Lethbridge, Lethbridge, AB T1K 3M4, Canada
b
Department of Economics, College of Business and Economics, Radford University, Radford, VA 24142, USA
c
College of Business, Texas AM University-Corpus Christi, Corpus Christi, TX 78412, USA Received 25 September 1998; accepted 7 April 1999
Abstract
This study examines the effects of poison putcall covenants on the reoffering yields of corporate bonds issued during 1986 through 1990. The analysis controls for possible biases
due to the endogeneity of the decision to issue the bond and the decision to include a poison covenant. The findings indicate that the presence of a single poison call provision has a positive
effect on the yield differential, increasing the yield by up to 54 basis points. This is consistent with the managerial entrenchment hypothesis. On the other hand, the inclusion of a poison
put provision reduces the yield by 58 to 78 basis points. Furthermore, we find that the imposition of an additional stringent provision to transfer a simple poison put to a super poison put does
not significantly decrease the yields further.
2000 Elsevier Science Inc. All rights reserved.
JEL classification: G32
Keywords: Poison putcall covenants; Debt financing; Bonds; Reoffering yield
1. Introduction
The explosive growth in leveraged buyouts and other leverage-increasing takeovers during the second half of the 1980s resulted in substantial wealth losses to bondholders
Asquith Wizman, 1990; Crabbe, 1991; Warga Welch, 1993. The main source of these losses was the increase in risk associated with the large amount of debt needed
to finance the transaction. The RJR Nabisco leveraged buyout made these wealth
Corresponding author. Tel.: 403-329-2249; fax: 403-329-2038. E-mail address
: khalil.torabzadehuleth.ca K.M. Torabzadeh 1059-056000 – see front matter
2000 Elsevier Science Inc. All rights reserved.
PII: S1059-05609900050-7
140 K.M. Torabzadeh et al. International Review of Economics and Finance 9 2000 139–156
losses painfully obvious to all market participants. Consequently, bondholders started requesting protection against takeover-related events that would damage the credit
quality of the firm. The protection demanded by bondholders, in turn, provided opportunities for incumbent managers to launch new defensive mechanisms in an
attempt to deter unwanted takeovers.
1
Hence, investors were offered bonds with a variety of protective covenants.
One category of covenants designed to protect bondholders against takeover-related losses includes the so-called poison call and poison put covenants. These covenants,
similar to poison pills, entitle their holders to special rights if an unanticipated event occurs. A poison put provision gives bondholders the right to require the firm to
redeem the bond at par sometimes at premium upon the occurrence of a designated event or a sequence of events that would likely impair bond values. A poison call
covenant, on the other hand, gives the company the right to call the bond if a risk event occurs. Some bond indentures contain both poison put and call provisions. The
designated events by which a call or put can be triggered are generally takeover related. In fact, almost every poison putcall that was issued prior to the 1988 RJR
buyout had a “change of control” as its designated event.
2
The RJR buyout and the subsequent downgrading of its bonds intensified the tension in the corporate bond
market and prompted bondholders to demand stronger and wider coverage. Bond issuers responded by offering stronger covenants called super poison puts. A super
poison put allows bondholders to redeem their bonds or reset the coupon to restore market value to par when a change in control happens andor the bonds are down-
graded by either Standard and Poor’s SP or Moody’s, or both. An example for each type of poison covenant is presented in the Appendix.
The specifics of each covenant differ. Some super poison puts require downgrading from investment to speculative grade for the puts to be triggered, while others are
triggered by downgrading within investment grades. Some provisions contain other risk events in addition to change of control. These differences led the SP to introduce
a five-scale event-risk rating scheme in July 1989. The scale ranges from E-1 strong protection to E-5 insignificant or no protection.
3
Moody’s Investor Service, on the other hand, directly incorporates event-risk in its overall assessment of bond
creditworthiness by assigning lower ratings to bonds with weaker protection. The effects of super poison puts on the reoffering yields are examined by Crabbe
1991. He finds that by including a super poison put a company is able to reduce its borrowing cost by an average of 24 basis points on the reoffering date. Crabbe’s
1991 findings are restricted to a sample of 31 E-rated bonds issued between November 1988 through December 1989: one bond is rated E1; 26 bonds are rated E3; and four
bonds are rated E4. Unfortunately, because of the limited sample size and insufficient data for all categories of E-ratings, it is difficult to draw a general conclusion regarding
the effects of different covenants on the reoffering yields of corporate bonds. Although not directly comparable, the findings of Asquith and Wizman 1990 provide evidence
of the importance of various forms of covenants in price performance of seasoned bonds facing an event risk. They analyze the returns to bondholders of firms involved
in leveraged buyouts and find different return distributions across bonds with different
K.M. Torabzadeh et al. International Review of Economics and Finance 9 2000 139–156 141
levels of covenant protection. They observe that bonds with strong protection gain, whereas those with weak or no protection lose value.
In addition to small sample size, Crabbe’s 1991 use of two categorical dummy variables firms with or without super poison puts produces a potential bias. The
source of this bias is the self-selection problem. His model yields consistent estimates only when the decision to include a covenant is exogenous or independent of the
decision to issue a bond. Given bondholders’ demands for stronger protection in the latter part of the 1980s, the condition of exogeneity was violated. In this peculiar
period, the inclusion of a poison covenant in the bond indenture became a major deciding factor affecting corporate financing strategy. The decision was particularly
important for those corporate borrowers that were viewed as possible takeover targets.
4
They had to decide whether to stay in the bond market and possibly meet bondholders’ demands, or to pursue an alternative form of financing. Those firms that decided to
stay in the bond market and at the same time decided not to include poison covenants and, as a result, were forced to offer bonds at higher yields, formed a distinct category
in the universe of bond issuers. Combining this group of firms with those firms for which investors demanded no poison covenants and comparing their yields with those
of issues with poison covenants, as in Crabbe 1991, yields biased estimates. Lehn and Poulsen 1991, commenting on Crabbe’s results, identify this bias as they state,
“unfortunately, these are conservative estimates since the presence of event-risk cove- nants is determined endogenously that is, firms that are not likely to receive leveraged
buyout offers are less likely to issue debt with event-risk covenants than other firms.”
A consistent estimate of the effect of the poison covenants on the reoffering yields should compare bonds with and without covenants issued by firms with similar proba-
bilities of takeover. Econometric methods to deal with the self-selection bias are described in Maddala 1983 and Greene 1993 and have been applied, among others,
by Smith 1987 in his study of the choice of issuance procedures.
This study extends that of Crabbe’s 1991 in a number of ways. First, this analysis uses a much larger sample than previous analyses. The sample includes most of the
industrial bonds with maturity of no less than seven years issued during 1986 through 1990. Second, the study examines the effects of all categories of poison covenants
i.e., simple poison call, simple poison put, and super poison put. Third, because of the takeover defensive properties of poison putcall provisions, the study addresses
the issue in conjunction with managerial entrenchment hypothesis and its implication for bondholders. Finally, this analysis controls for possible self-selection bias to provide
consistent estimates of the effects of the poison covenants on the reoffering yields.
The results of the study show that the inclusion of a simple poison call has positive effect upon reoffering yields, increasing the yield by up to 54 basis points. This is
consistent with the managerial entrenchment motives. On the other hand, the inclusion of a poison put reduces reoffering yields by 58 to 78 basis points. Interestingly, the
imposition of an additional stringent provision to transfer a simple poison put to a super poison put does not significantly decrease the yields further.
The organization of the remainder of this article is as follows. Section 2 discusses the hypotheses concerning various types of poison covenants and their expected effects
142 K.M. Torabzadeh et al. International Review of Economics and Finance 9 2000 139–156
on the bond prices. Section 3 defines the sample, data, and methodology. Section 4 presents and discusses the results, while Section 5 concludes the paper.
2. Hypotheses
