48 Pages Posted: 12 Jul 2012 Last revised: 19 Aug 2017
Date Written: August 6, 2017
We use an exogenous, accounting-based shock to debt covenants (SFAS 160) to explore whether such covenants unnecessarily restrict leverage. Incomplete contract theory suggests that covenants are set too tightly to aid future renegotiations. Therefore, we argue that covenants constrain leverage for borrowers that are close to violation, even when the borrower is financially healthy. We find that the shock that relaxed covenant tightness led to increased debt levels in firms that had been close to violation. This increase in debt among covenant-constrained firms was driven by financially healthy firms, suggesting the covenants were repressing debt levels. We also find an increase in the investment sensitivity to Q in covenant-constrained firms after the shock, suggesting the additional debt was used in sound investment decisions. Overall, our evidence suggests that covenant-based monitoring restricts financially-healthy firms’ ability to access external funds for profitable investments.
Keywords: Debt, covenants, financial constraints, leverage, investments, default
JEL Classification: G01, G30, G31, G33, M21, M41
Suggested Citation: Suggested Citation
Cohen, Moshe and Katz, Sharon P. and Mutlu, Sunay and Sadka, Gil, Do Debt Covenants Unnecessarily Constrain Leverage? Evidence from SFAS 160 (August 6, 2017). Available at SSRN: https://ssrn.com/abstract=2102878 or http://dx.doi.org/10.2139/ssrn.2102878
By Amir Sufi