The Structure and Pricing of Corporate Debt Covenants
Michael Bradley and Michael R. Roberts
This paper based on a sample of 12,425 private corporate loans made to 3,012 unique firms during the period 1993-2001 examines the corporate bond covenants along several dimensions like in terms of sample size, time horizon, diversity of borrowers and lenders, supply side and macroeconomic factors on the contracting process. The sample of loans contains covenants on 17 different accounting variables, including the interest coverage ratio, current ratio, leverage and net worth. The focus of attention of this paper is on private debt market, which is the primary source of corporate financing. Private debt contains far more covenants than does public debt.
Agency Theory of Covenants (ATC) provides a rationale for the presence of covenants in debt contracts. The central theme of this theory is the conflict of interest between shareholders and bondholders, which results in actions by managers that have a negative impact on the value of the firm’s outstanding debt as well as the total value of the firm. The theory predicts that small, highly levered, volatile firms, with highly liquid assets and significant information asymmetries would be more likely to include covenants in their debt agreements.
The statistical analysis of the covenant structure of corporate debt is done with a creation of a covenant index for each issue meant to measure the degree to which a particular loan restricts the actions of the firm’s management. The covenant index was regressed on loan details, borrower characteristics, lender characteristics and macroeconomic factors based on Poisson regression. A probit model of loan pricing and covenant inclusion which determines the inclusion of particular covenants in a given loan contract is also utilized in the study.
The study finds evidence on the determinants of covenant structure that is largely supportive of the predictions of the ATC. High growth firms are more likely to issue loans with dividend restrictions, security requirements and financial constraints than less growth-oriented firms. Private Debt Issuers are significantly smaller in terms of assets, market capitalization and sales than firms that issue public debt. The findings of the study are consistent with the fact that that bank debt covenants are easier to renegotiate and are thus less costly than covenants written into public debt.
A highly significant, positive association between the promised yield and the number of covenants was observed. There exists positive association between the maturity of a loan and the index, suggesting that covenants act to reduce the effective maturity of the loan.
The highly significant positive relation between performance pricing and the covenant index indicates that covenants and performance pricing are complements. Firm size is another important element in determining the covenant structure of loans. The macroeconomic factors also play a role in the determination of the covenant structure of corporate bonds. The greater the credit spread, the greater the number of covenants, which is consistent with the agency theory of contracts. Supply-side factors also affect the covenant choice decision as well. The study empirically demonstrates that the decision to include covenants in a loan agreement and the pricing of the loan are determined simultaneously. It is also found that loans made during stock market downturns are more likely to contain restrictive covenants.
Bradley, Michael H. and Roberts, Michael R., "The Structure and Pricing of Corporate Debt Covenants" (May 13, 2004).
Available at SSRN: http://ssrn.com/abstract=466240 or DOI: 10.2139/ssrn.466240
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