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Conflicting Priorities: A Theory of Covenants and Collateral

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  • JASON RODERICK DONALDSON
  • DENIS GROMB
  • GIORGIA PIACENTINO

Abstract

We develop a theory of secured debt, unsecured debt, and debt with anti‐dilution covenants. We assume that, as in practice, covenants convey the right to accelerate if violated, but the new secured debt retains its priority even if issued in violation of covenants. We find that such covenants are nonetheless useful: They provide state‐contingent financing flexibility, balancing over‐ and underinvestment incentives. The optimal debt structure is multilayered, combining secured and unsecured debt with and without covenants. Our results are consistent with observations about debt structure, covenant violations, and waivers. They speak to a policy debate about debt priority.

Suggested Citation

  • Jason Roderick Donaldson & Denis Gromb & Giorgia Piacentino, 2025. "Conflicting Priorities: A Theory of Covenants and Collateral," Journal of Finance, American Finance Association, vol. 80(3), pages 1739-1768, June.
    • Handle: RePEc:bla:jfinan:v:80:y:2025:i:3:p:1739-1768
    DOI: 10.1111/jofi.13445
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