Debt Covenants and the Expected Cost of Technical Default

Abstract

To estimate the expected cost of technical default for equityholders, we analyze the stock market reaction to changes in the ex-ante likelihood of technical default. Our large-sample, ex-ante estimates exceed five percent of equity value, which reflects material monetary and risk consequences of lender control. Small-sample, ex-post estimates using market reactions to default announcements are smaller, consistent with anticipation and selection. In cross-sectional tests, we find that equityholders anticipate technical defaults and that renegotiating borrowers' ex-ante expected technical default costs exceed that of defaulters. Moreover, we show that creditor coordination and monitoring problems increase the expected cost of default.

Keywords: debt covenants, technical default, control rights, shareholder-debtholder conflict

JEL Classification: G14, G32, G33, M41