Debt Covenants and Bankruptcy Risk

Abstract:     
Riskier firms use more covenants, yet effective covenants should reduce the probability of bankruptcy by restricting management’s actions. We disentangle these two relations between covenant use and bankruptcy risk by considering predicted and actual covenant use in corporate bonds and bank loans. In our bond sample, we find that predicted covenant use is associated with a higher probability of bankruptcy and shorter firm survival, whereas actual covenant use is associated with a lower probability of bankruptcy and longer firm survival. This evidence is consistent with the notion that the use of covenants reduces bankruptcy risk. In contrast, in our bank loan sample, we find that predicted covenant use has no impact on bankruptcy, whereas actual covenant use is related to a higher probability of bankruptcy. The different results between corporate bonds and bank loans suggest that initial covenant restrictions in bank loans are less binding than those in corporate bonds. This is consistent with the existing literature which finds that a violation of bank loan covenants often leads to debt renegotiation rather than bankruptcy.

Number of Pages in PDF File: 48

Keywords: bond covenants, loan covenants, bankruptcy risk

JEL Classification: G10, G12, G32

working papers series