Debt Heterogeneity and Covenants
65 Pages Posted: 25 Jul 2013 Last revised: 21 Dec 2017
Date Written: December 21, 2017
Coordination failure among owners of heterogeneous debt types increases distress costs. Covenants reduce expected distress costs by lowering the probability of liquidity shortages, increasing liquidation values, and incentivizing creditor monitoring. We predict and find that new debt contracts include more covenants when borrowers' existing debt structures are more heterogeneous. Our findings suggest that covenants are not only used to address creditor-shareholder conflicts but also to reduce the expected costs of coordination failure among creditors. Further, our results indicate a dynamic component missing from static debt structure models: Debt heterogeneity entails additional covenants (i.e., constraints) when raising future debt.
Keywords: Debt Heterogeneity, Debt Covenants, Creditor Conflicts, Coordination Failure
JEL Classification: G32
Suggested Citation: Suggested Citation