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Debt Covenants and Cross-Sectional Equity Returns

Author

Listed:
  • Jean Helwege

    (University of California, Riverside, Riverside, California 92521)

  • Jing-Zhi Huang

    (Pennsylvania State University, University Park, Pennsylvania 16802)

  • Yuan Wang

    (Concordia University, Montréal, Quebec H3G 1M8, Canada)

Abstract

This paper investigates the impact of debt covenant protection on the cross section of equity returns with a firm-level covenant index and four subindices. We find that firms with weaker covenant protection (lower covenant index levels) earn significantly higher risk-adjusted equity returns than do those firms with greater covenant protection. These results are stronger for covenant indices that are related to investments, subsequent financing, and event risk. The difference between high and low covenant index stocks is more pronounced when agency problems between shareholders and debtholders are more severe, suggesting that the covenant effect arises from an inability to control shareholder risk taking.

Suggested Citation

  • Jean Helwege & Jing-Zhi Huang & Yuan Wang, 2017. "Debt Covenants and Cross-Sectional Equity Returns," Management Science, INFORMS, vol. 63(6), pages 1835-1854, June.
    • Handle: RePEc:inm:ormnsc:v:63:y:2017:i:6:p:1835-1854
    DOI: 10.1287/mnsc.2015.2381
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