Debt Covenants and Cross-Sectional Equity Returns
Management Science, Forthcoming
48 Pages Posted: 20 Mar 2012 Last revised: 5 Sep 2015
Date Written: December 20, 2013
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: Suggested Citation