Firm Debt Covenants and the Macroeconomy: The Interest Coverage Channel

47 Pages Posted: 6 Mar 2020

See all articles by Daniel Greenwald

Daniel Greenwald

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Date Written: July 15, 2019

Abstract

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

Greenwald, Daniel, Firm Debt Covenants and the Macroeconomy: The Interest Coverage Channel (July 15, 2019). MIT Sloan Research Paper No. #5909-19, Available at SSRN: https://ssrn.com/abstract=3535221 or http://dx.doi.org/10.2139/ssrn.3535221

Daniel Greenwald (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

77 Massachusetts Ave. E62-663
Cambridge, MA 02142
United States

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