Death Spiral Convertibles

Death spiral convertibles are privately-held convertible securities (preferred stock or debentures) with a conversion price that is set at a discount from the average (or sometimes the minimum) of past stock prices in a look-back period. Although in theory these securities have the potential to reduce agency costs of debt and problems related to adverse selection, they have been called "death spirals" because of their potential to create dilution and stock price declines. On the basis of all 487 issues announced before August 1998, the authors find that this reputation is indeed justified: an investor who buys the common stock of the issuer loses, on average, 34% of his wealth one year after the issue date. Although their sample period coincided with one of the strongest bull markets in US history, in 85% of the cases one-year post-announcement returns were negative. The most important predictor of poor long-term performance is the discount. However, they also find that issuers also experience a significant decline in operating profitability relative to benchmark firms.