Uncertainty and Debt Covenants
60 Pages Posted: 25 May 2012 Last revised: 22 Apr 2017
Date Written: April 21, 2017
I examine the use of financial covenants when contracting for debt under uncertainty. Uncertainty, in the context of this study, is a lack of information about future economic events and their consequences for the borrower's creditworthiness. I examine the implications of ex-ante uncertainty that is resolved by information received following loan initiation but prior to maturity. I argue that financial covenants, by transferring control rights ex-post, provide a trigger for creditor-initiated renegotiation when the borrower is revealed to be of low credit quality. Using a large sample of private loans, I predict and find that financial covenant intensity is associated with greater uncertainty. I also revisit the agency-based explanation for covenant use and find that this uncertainty explanation is robust to various controls for agency conflicts.
Keywords: debt contracting, financial covenants, agency problems, renegotiation
JEL Classification: G21, G32, M41
Suggested Citation: Suggested Citation