Do Bond Covenants Affect Borrowing Costs?

8 Pages Posted: 9 Jul 2014

See all articles by Martin S. Fridson

Martin S. Fridson

Lehmann, Livian, Fridson Advisors LLC

Xiaoyi Xu

FridsonVision LLC

Ruili Liu

FridsonVision LLC

Yinqiao Yin

Bond Street Group

Date Written: Spring 2014

Abstract

High yield bond investors spend a great deal of time studying covenants. They even hire specialized consultants to help them interpret the dense language of indentures. But for all that, does a company's decision to offer strong rather than weak covenants—or to offer covenants at all—have a measurable impact on its borrowing costs?. There is surprisingly little evidence that variation in credit risk premiums reflects the presence or absence of covenants. Taking advantage of a newly available kind of data—Moody's Investors Service's Covenant Quality (CQ) ratings, which were initiated in 2011—the authors studied each newly issued U.S. high yield bond beginning in 2011 using Moody's CQ ratings, where a rating of “1” represents the strongest covenant rating and “5” the weakest. The authors hypothesize that if investors are willing to pay for covenant protection, bonds with weak CQ scores should have spreads that are higher, on average, than the medians of the bonds in their rating group. What they found, however, was that even bonds rated CQ5, indicating negligible protection, had spreads that were only 9.54 basis points higher than the median of companies with the same credit rating. The authors also found, contrary to their initial supposition, that higher yields were associated with stronger covenants, suggesting that investors demand more protection on issues they view as having greater credit risk than other equivalently rated issues.

Suggested Citation

Fridson, Martin S. and Xu, Xiaoyi and Liu, Ruili and Yin, Yinqiao, Do Bond Covenants Affect Borrowing Costs? (Spring 2014). Journal of Applied Corporate Finance, Vol. 26, Issue 2, pp. 79-84, 2014, Available at SSRN: https://ssrn.com/abstract=2463910 or http://dx.doi.org/10.1111/jacf.12069

Martin S. Fridson

Lehmann, Livian, Fridson Advisors LLC ( email )

136 E 57th Street
Suite 501
New York, NY 10022
United States

Xiaoyi Xu

FridsonVision LLC

54 West 21st Street
Suite 1007
New York, NY 10010
United States

Ruili Liu

FridsonVision LLC

54 West 21st Street
Suite 1007
New York, NY 10010
United States

Yinqiao Yin

Bond Street Group

261 Madison Ave
New York, NY 10018
United States

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