Poison Put Bonds: An Analysis of Their Economic Role

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. 1905

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