Debt Dilution, Debt Covenants, and Macroeconomic Fluctuations

29 Pages Posted: 17 Oct 2023 Last revised: 26 Oct 2023

See all articles by Min Fang

Min Fang

University of Florida - Department of Economics

Wentao Zhou

UW-Madison

Date Written: October 17, 2023

Abstract

Debt covenants are pervasive in debt contracts. To prevent the dilution of existing debt, most creditors set covenants of a maximum debt-to-earnings ratio for borrowing firms. In this paper, we embed debt covenants into a workhorse real business cycle model with defaultable long-term debt to study its macroeconomic implications. In our model, creditors penalize firms when covenants are violated. We show such a mechanism that covenants significantly reduce debt dilution and default over the business cycles. Furthermore, reduced debt dilution due to covenants also mitigates the debt overhang problem and thus boosts capital accumulation. Compared to counterfactual economies without covenants, the baseline economy with covenants experiences endogenous stabilization of macroeconomic shocks and higher levels of capital, output, and consumption.

Keywords: Debt Covenants; Debt Dilution; Financial Frictions; Business Cycle;

JEL Classification: E32, E44, G32

Suggested Citation

Fang, Min and Zhou, Wentao, Debt Dilution, Debt Covenants, and Macroeconomic Fluctuations (October 17, 2023). Available at SSRN: https://ssrn.com/abstract=4604335

Min Fang (Contact Author)

University of Florida - Department of Economics ( email )

224 Matherly Hall
Gainesville, FL 32606
United States

HOME PAGE: http://www.minfang.info

Wentao Zhou

UW-Madison ( email )

1180 Observatory Drive
Madison, WI 53706
United States
6089826691 (Phone)
53703 (Fax)

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