Borrowers and lenders have at their disposal a number of contracting mechanisms to help ensure a healthy lending relationship, including, for example, security classes, maturities, and covenants. This study examines the contracting consequences of one of those mechanisms, the covenant contracting package. Specifically, the study analyzes the association between the inclusion of accounting-based financial (ABF) covenants in public debt and the likelihood of substantive default and credit rating downgrade. Covenants are intended to protect the interests of lenders who wish to avoid substantive default and minimize losses and economic inefficiencies associated with such outcomes.
Within the covenant choice set, one such incentive mechanism lenders can impose on borrowers are ABF covenants. Relative to boilerplate covenants, ABF covenants arguably provide lenders with a more effective monitoring tool since determination of their violation is fairly straightforward. When faced with the possibility of breaching an easily verifiable ABF covenant, borrowers may take preventative actions (e.g., less risky decision making ex-ante) in order to maintain compliance. Alternatively, breach of a covenant can trigger renegotiation which may force borrowers to make changes in real actions ex-post, such as reductions in issuance or investment activities (Chava and Roberts (2008), Roberts and Sufi (2009)).
The role ABF covenants play in public debt is less clear given the paucity of such covenants in this setting. In private debt, covenants serve as a trigger for renegotiating upon violation with a small class of well-informed lenders. In public debt, however, the option to renegotiate upon violation is typically unavailable. First, renegotiation of public debt is generally more difficult than private debt due to strict reliance on publicly available information and the need to establish consensus amongst a diffuse body of bondholders.
Second, given how loosely covenants are set in public debt as a result of coordination problems, once a covenant has been violated, public firms are likely too near to bankruptcy to allow for successful renegotiation which leads lenders to hasten acceleration in order to maximize recovery after covenant violation. Confronted with this threat, managers must pursue ex-ante means in order to avoid technical default, such as making less risky operating or investing decisions or renegotiating ahead of default.
Rather than allow lenders to minimize losses in recovery after an event of default, the presence of an ABF covenant in public debt provides managers with a credible incentive mechanism to take preventative actions which minimize their own losses associated with an event of default, and in doing so, avoid potential deadweight loss. Without such covenants, preventative actions are likely to occur on a less timely basis, which may translate into a higher frequency of "surprise" defaults. To test for this conjecture, the paper analyzes the relation between ABF covenants and substantive defaults, as well as credit rating downgrades, where managerial preemption is expected to be the first order effect. This analysis is supplemented with an investigation of offering yields to determine if lenders compensate borrowers for the additional constraint.
Download
The Role of Accounting-based Financial Covenants in Preventing Substantive Defaults of Public Debt
