The Defeasance of Control Rights

Abstract

We analyze one frequently used clause in public bonds called covenant defeasance. Covenant defeasance allows the bond issuer to remove all of the bond's covenants by placing the remaining outstanding payments with a trustee in an escrow account to be paid out on schedule. Bond covenants are predominantly noncontingent, action-limiting covenants. By giving the issuer an option to remove covenants, noncontingent control rights can be made state-contingent even when no interim signals are available. We provide a theoretical justification for covenant defeasance and show empirically that such a clause allows for the inclusion of more covenants in public bond issues. In line with the model's prediction, our empirical analysis documents a 13-25 basis points premium for defeasible bonds. This premium amounts to an annual saving of about $1m per year, or $11m over the lifetime of an average bond.

Keywords: Bonds, Covenants, Defeasance, Renegotiation

JEL Classification: G32, D86, G12