Debt Covenant Violations, Credit Default Swap Pricing, and Borrowing Firms’ Accounting Conservatism
55 Pages Posted: 17 Jan 2019 Last revised: 10 Mar 2019
Date Written: January 16, 2019
We investigate the impact of debt covenant violations (DCVs) on credit risk reflected in credit default swap (CDS) spread, and how the two elements, combined together, affect the relation between DCVs and financial reporting conservatism of borrowing firms that are referenced in CDS contracts. We find that DCVs induce a significant increase in CDS spreads during the trading days subsequent to borrowers’ SEC filing dates, indicating increased credit risk of borrowing firms upon DCVs. We also find that borrowing firms’ financial reporting becomes more conservative post DCVs, especially when borrowing firms’ CDS spreads incur large increases and their institutional shareholders play a stronger role of external monitoring. Our finding of increased CDS spreads upon DCVs is consistent with the view that CDS-protected lenders lack incentives to exercise their control rights. To the extent that lenders do not intervene in borrowers’ financial reporting, our finding of increased conservatism suggests that borrowing firms tend to report more conservatively under the influence of other stakeholders such as institutional investors whose equity investment are not protected by credit insurance CDS.
Keywords: Debt Covenant Violation; Credit Default Swap; CDS Spreads; Accounting Conservatism; Institutional Holdings
JEL Classification: G12; G14; M41
Suggested Citation: Suggested Citation