Poison Put Bonds: An Analysis of Their Economic Role

Abstract

JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org. This content downloaded from 128.235.251.160 on Wed, ABSTRACT This article examines the effect of issuing debt with and without "poison put" covenants on outstanding debt and equity claims for the period 1988 to 1989. The analysis shows that "poison put" covenants affect stockholders negatively and outstanding bondholders positively, while debt issued without such covenants has no effect. The study also finds a negative relationship between stock and bond returns for firms issuing poison put debt. These results are consistent with a "mutual interest hypothesis," which suggests that the issuance of poison put debt protects managers and, coincidentally, bondholders, at the expense of stockholders.A CONTRACTUAL INNOVATION, KNOWN generically as "poison puts" or "super poison puts," has been introduced in the corporate bond market in recent years. The two principal covenants devised are put options and coupon adjustments triggered by the occurrence of "risk events" like hostile takeovers, acquisition of large stakes in firms (e.g., 30 percent), leveraged buyouts, and leveraged recapitalizations. One alleged purpose is to insulate managers from the market for corporate control. Alternatively, these covenants could be introduced to shelter bondholders from reductions in bond value that sometimes occur concurrently with corporate control activity. This article examines the effect on bondholder and stockholder wealth of issuing debt with these provisions and draws inferences about the true economic roles that they perform.Section I of the article describes the possible economic roles of event risk covenants and the implications of the issuance of these bonds for the value of the firm's stock and outstanding debt. Section II describes the sample and data used in this study. Section III outlines the methodology for assessing stockholder and bondholder wealth effects. Finally, Section IV presents the results of the empirical tests, and Section V concludes. I. Economic Roles of Event Risk CovenantsEvent risk covenants or "poison puts" could be included in corporate debt for three reasons. First, poison puts, as the name suggests, could be designed to *Cook is from the Financial Institutions Center at the Wharton School, University of Pennsylvania, and Easterwood is from Virginia Polytechnic and State University. We wish to thank Dave Denis, Meir Schneller, Rene Stulz (the editor), and an anonymous referee for helpful comments. We also wish to thank Melissa Neumann of Lehman Brothers for providing bond index data.

Firm Characteristics and the Presence of Event Risk Covenants in Bond Indentures

“…These results suggest that a firm's agency costs of debt may be an important factor in determining the presence of ERCs in bond indentures. On the other hand, Cook and Easterwood (1994) find evidence supporting the view that the issuance of ERC‐protected bonds protects both managers and bondholders from hostile takeovers at the expense of stockholders. Their results suggest that a firm's degree of managerial entrenchment, or potential for takeover, plays an important role in determining the presence of ERCs in bond indentures.…”

“…We intend to fill this gap by examining, through logistic regression analysis, the effect of these two firm characteristics on the decision to include ERCs in bond indentures. Since our analysis and results do not rely on the estimation of abnormal returns around the announcement dates of bond issuances, as do the studies by Bae, Klein, and Padmaraj (1994) and Cook and Easterwood (1994), our results are free from potential estimation bias. Furthermore, our results provide new empirical evidence on the relation of these two firm characteristics to the presence of ERCs.…”

“…Bae, Klein, and Padmaraj (1994) and Cook and Easterwood (1994) examine the effect of ERC‐protected bonds on stockholder wealth, with contrasting results. Bae, Klein, and Padmaraj (1994) find that the issuance of ERC‐protected bonds has a more positive effect on stockholder wealth than the issuance of nonprotected bonds.…”

Impact of New Debt Offerings on Existing Corporate Bondholders

“…Seminal work by Galai and Masulis (), Jensen and Meckling (), Myers (), and Smith and Warner () suggests that bondholder‐protective or issuer‐restrictive covenants can be used to protect bondholders. Cook and Easterwood () report that a firm's existing bonds tend to increase in value upon the issuance of new bonds with change‐in‐control covenants. Billett, Jiang, and Lie () find that bondholders with change‐in‐control covenant protection experience positive wealth effects surrounding the announcement of a leveraged buyout (LBO); that is, the existence of change‐in‐control covenants reduces the firm's probability of being targeted in an LBO.…”

Pricing the Strategic Value of Poison Put Bonds

“…We estimate that poison puts have accounted for about 12 percent of all bonds issued by U.S. nonnancial companies in the 1990s. While the roles of poison puts as anti-takeover defenses and as providing investors protection against event-risk (see for example, Crabbe 1991, Cook andEasterwood 1994) the threatening power of poison put bondholders | the ability to induce a nancial crisis | has largely been ignored. In times of low liquidity for the rm, put bondholders can threaten to either force the company i n to a reorganization or raise its borrowing costs.…”