Accounting-based Expected Loss Given Default and Debt Contract Design
41 Pages Posted: 2 Aug 2011 Last revised: 19 Feb 2021
Date Written: February 10, 2021
We investigate an unexplored channel—loss given default (LGD)—through which accounting information can shape the design of debt contracts. Using a sample of defaulted bonds, we find that borrower accounting information available at contract initiation possesses significant power for predicting realized LGD at the subsequent default date. We then use this model to construct an accounting-based measure of expected LGD at the contracting date for a large sample of bond issuances. We find that this measure is positively associated with issuance date interest spread and covenant use, and document that these relations are not artifacts of an association between LGD and probability of default. We then show that accounting-based expected LGD has a stronger association with issuance date spread when the borrower’s underlying accounting is more conservative, consistent with the idea that expected LGD calculations provide a source of lenders’ demand for accounting conservatism. Our results increase our understanding of both the informational role and contracting role of accounting information.
Keywords: Debt contracts; Loss given default; Conservatism
JEL Classification: G12, M40, M41
Suggested Citation: Suggested Citation