Debt Covenants, Bankruptcy Risk, and Issuance Costs

57 Pages Posted: 9 Apr 2011 Last revised: 22 Aug 2013

Sattar Mansi

Virginia Tech

Yaxuan Qi

City University of Hong Kong (CityUHK) - Department of Economics & Finance

John K. Wald

University of Texas at San Antonio

Multiple version iconThere are 2 versions of this paper

Date Written: August 21, 2013

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. 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. However, theory suggests that two covenants -- stock issuance restrictions and rating decline puts -- do not reduce the probability of bankruptcy. Empirically, we find that the use of either of these covenants implies a higher probability of bankruptcy and a shorter survival time. On the cost side, we find evidence that corporate bonds with more restrictive covenants have higher issuance costs. While we find some evidence that bonds with more covenants are more difficult to sell, we argue that this covenant-issue cost relation is mainly driven by the risk to underwriters. Overall, these results both confirm some essential aspects of, and expand upon, Smith and Warner’s (1979) costly contracting hypothesis.

Keywords: bond covenants, loan covenants, bankruptcy risk

JEL Classification: G10, G12, G32

Suggested Citation

Mansi, Sattar and Qi, Yaxuan and Wald, John K., Debt Covenants, Bankruptcy Risk, and Issuance Costs (August 21, 2013). Available at SSRN: https://ssrn.com/abstract=1805038 or http://dx.doi.org/10.2139/ssrn.1805038

Sattar Mansi

Virginia Tech ( email )

Yaxuan Qi (Contact Author)

City University of Hong Kong (CityUHK) - Department of Economics & Finance ( email )

83 Tat Chee Avenue
Kowloon
Hong Kong

John K. Wald

University of Texas at San Antonio ( email )

1 UTSA Circle
San Antonio, TX 78249
United States
210-458-6324 (Phone)

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