Managerial Moral Hazard and Bond Covenants

Abstract

Based on an analysis of the agency risk for bondholders from managerial entrenchment and fraud, and using an efficient contracting framework, we derive and test refutable hypotheses about the influence of managerial moral hazard on the use of bond covenants. Entrenched managers can both exacerbate and ameliorate bondholder agency risk, and the influence of fraud risk on bond covenants is determined by the quality of information on the firms' net assets and economic prospects. Our empirical analysis indicates that managerial entrenchment and the risk of managerial fraud significantly influence the use of covenants, in the direction predicted by our agency-theoretic analysis. Moreover, the use of covenants responds to cross-sectional variations in the firms' informational environment that influence the risk of managerial fraud. We also find that the Sarbanes-Oxley Act (SOX) has not significantly influenced the overall use of bond covenants; however, the passage of SOX appears to have reduced the agency risk to bondholders from managerial moral hazard with respect to investment.

Keywords: Corporate bonds, bond covenants, costly contracting hypothesis, agency costs

JEL Classification: G3