Anticipating Binding Constraints: An Analysis of Debt Covenants

Abstract

This paper shows that anticipation can meaningfully impact inferences about the effects of covenant violations. Using textual analysis of SEC filings and earnings call transcripts, I construct a measure of covenant concerns that identifies instances where firms disclose forward-looking risks related to their debt covenants. On average, nearly 30 percent of U.S. non-financial firms report covenant concerns each year. While covenant violations have significant real effects, the anticipation of such violations can lead to an overestimation of their impact on some outcomes like acquisitions, employment growth, and default risk. This finding suggests that selection into violation, where firms that successfully avoid violations differ systematically from those that do not, can be severe when there is anticipation.

Keywords: debt covenants, investments, textual analysis, earnings calls

JEL Classification: G21, G31, G32