Firm Debt Covenants and the Macroeconomy: The Interest Coverage Channel
47 Pages Posted: 6 Mar 2020
Date Written: July 15, 2019
Interest coverage covenants, which set a maximum ratio of interest payments to earnings, are among the most popular provisions in firm debt contracts. For affected firms, the amount of additional debt that can be issued without violating these covenants is highly sensitive to interest rates. Combining a theoretical model with firm-level data, I find that interest coverage limits generate strong amplification from interest rates into firm borrowing and investment. Importantly, most firms that have interest coverage covenants also face a maximum on the ratio of the stock of debt to earnings. Simultaneously imposing these limits implies a novel source of state-dependence: when interest rates are high, interest coverage limits are tighter, amplifying the influence of interest rate changes and monetary policy. Conversely, in low-rate environments, debt-to-earnings covenants dominate and transmission is weakened.
Keywords: debt covenants, interest coverage, interest rate transmission, state dependence
JEL Classification: E43, E44, G32
Suggested Citation: Suggested Citation