Debt Covenants and Cross-Sectional Equity Returns

Management Science, Forthcoming

48 Pages Posted: 20 Mar 2012 Last revised: 5 Sep 2015

See all articles by Jean Helwege

Jean Helwege

UC Riverside

Jing-Zhi Huang

Pennsylvania State University - University Park - Department of Finance

Yuan Wang

Concordia University, Quebec

Date Written: December 20, 2013

Abstract

This paper investigates the impact of debt covenant protection on the cross section of equity returns with a firm-level covenant index and four sub-indices. We find that firms with weaker covenant protection (lower covenant index levels) earn significantly higher risk-adjusted equity returns than do those firms with greater covenant protection. These results are stronger for covenants indices that are related to investments, subsequent financing and event risk. The difference between high and low covenant index stocks is more pronounced when agency problems between shareholders and debtholders are more severe, suggesting that the covenant effect arises from an inability to control shareholder risk-taking.

JEL Classification: G11, G12, G3

Suggested Citation

Helwege, Jean and Huang, Jing-Zhi Jay and Wang, Yuan, Debt Covenants and Cross-Sectional Equity Returns (December 20, 2013). Management Science, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2024755 or http://dx.doi.org/10.2139/ssrn.2024755

Jean Helwege

UC Riverside ( email )

900 University Ave.
Anderson Hall
Riverside, CA 92521
United States
9518274284 (Phone)

Jing-Zhi Jay Huang

Pennsylvania State University - University Park - Department of Finance ( email )

University Park, PA 16802
United States

HOME PAGE: http://www.personal.psu.edu/jxh56

Yuan Wang (Contact Author)

Concordia University, Quebec ( email )

1455 de Maisonneuve Blvd. W.
Montreal, Quebec H3G 1MB
Canada

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