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Are Bond Covenants Priced?

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  • Michael R Roberts
  • Michael Bradley

Abstract

In this paper we ask the empirical question are bond covenants priced? Consistent with the Costly Contracting Hypothesis (CCH) developed by Smith and Warner (1979), we find that they are. We document a negative relation between the promised yield on corporate debt issues and the presence of covenants. We also find that loans made to high-growth firms are more likely to include restrictive covenants than loans made to low-growth firms. We show that the inclusion of a covenant varies systematically with macroeconomic factors as well as with supply-side factors, especially the identity of the lending institution. Finally, we show that consistent with the CCH, firms that elect to issue private rather than public debt are smaller, have greater growth opportunities, less long term debt, fewer tangible assets, and include more covenants in their debt agreements. An important byproduct of our analysis is to demonstrate empirically that the decision to include a covenant and the corresponding promised yield are determined simultaneously. Consequently, statistical models that ignore this simultaneity in analyzing the effects of covenants, like single-equation probit models, are misspecified and generate unreliable statistics

Suggested Citation

  • Michael R Roberts & Michael Bradley, 2004. "Are Bond Covenants Priced?," Econometric Society 2004 North American Summer Meetings 7, Econometric Society.
    • Handle: RePEc:ecm:nasm04:7
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    File URL: http://repec.org/esNASM04/up.21166.1069857472.pdf
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    References listed on IDEAS

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    5. Mark T. Leary & Michael R. Roberts, 2005. "Do Firms Rebalance Their Capital Structures?," Journal of Finance, American Finance Association, vol. 60(6), pages 2575-2619, December.
    6. Barclay, Michael J & Smith, Clifford W, Jr, 1995. "The Maturity Structure of Corporate Debt," Journal of Finance, American Finance Association, vol. 50(2), pages 609-631, June.
    7. Kahan, Marcel & Yermack, David, 1998. "Investment Opportunities and the Design of Debt Securities," The Journal of Law, Economics, and Organization, Oxford University Press, vol. 14(1), pages 136-151, April.
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    9. Nash, Robert C. & Netter, Jeffry M. & Poulsen, Annette B., 2003. "Determinants of contractual relations between shareholders and bondholders: investment opportunities and restrictive covenants," Journal of Corporate Finance, Elsevier, vol. 9(2), pages 201-232, March.
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    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Agency Costs; Costly Contracting; Debt Covenants;
    All these keywords.

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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