How Legal Environments Affect the Use of Bond Covenants
52 Pages Posted: 21 Mar 2009 Last revised: 21 Jul 2013
Date Written: December 15, 2009
We examine how country-level legal and institutional investor protection shapes contractual creditor protection. Using debt covenant information for foreign bonds issued in the U.S., we find that bonds of firms incorporated in countries with stronger creditor rights use fewer covenants. This finding suggests that creditor protection substitutes for covenants in reducing the agency cost of debt. In contrast, bonds of firms from countries with stronger shareholder rights use more covenants. Similarly, we find that firms with stronger firm-level corporate governance include more covenants in debt contracts. These findings support the view that firms with stronger shareholder control may face an increase in the shareholder-bondholder conflict and therefore prefer to use more covenants. In addition, we find that the enforcement of laws is positively related to the use of covenants, while the existence of a public credit registry mechanism is negatively related to covenant use.
Keywords: Covenants, contracts, creditor rights, shareholder rights, corporate governance
JEL Classification: G38, K22
Suggested Citation: Suggested Citation