Ebook The Use of Debt Covenants in Public Debt: The Role of Accounting Quality and Reputation
The use of accounting numbers in lending agreements is considered to be an important part of the demand for accounting. The accounting choice literature hypothesizes that managers make accounting choices, such as manipulating net income, to avoid tripping accounting-based loan covenants. Much of this body of research presumes that debt covenants are frequently used and that the form of the covenants is standard boiler-plate. However, recent research by Begley and Freedman [2004] calls into question the prevalence and importance of loan covenants.
They examine the use of accounting-based covenants in senior public debt issued in three different time periods (the late 1970s, 1989-1993 and 1999-2002), reporting that covenant use has declined sharply over the last three decades. In addition, they find that the form of debt covenants appears to be shifting away from measures that can be affected by accounting choices to measures that are closer to cash flows. While Begley and Freedman uncover some interesting data regularities, they do not investigate explanations for this dramatic change.
This study is concerned with understanding what factors influence the choice of debt covenants in public lending agreements and what has changed over time to alter the observed distribution of covenants. Our analysis endeavors to explain cross-sectional covenant use with traditional agency problem proxy variables, plus variables to indicate reputation and accounting quality effects. We build on an existing literature that uses agency theory to explain debt covenant use. This literature proposes that debt covenants are used to control conflicts of interest between stockholders and bondholders. One possible explanation for why covenant use has changed over time is that the types of firms issuing public debt may have changed. There have been many innovations to corporate financing alternatives over the last three decades.
In the late 1970s the high yield, junk bond market (Bond rated below BBB) came into vogue attracting many high risk companies to the public debt market. This continued into the 1980s with the onset of the LBO market. While in the 1990s there was an explosion in the use of asset securitizations. It is therefore possible that, the earlier time periods saw riskier firms, with more opportunities for agency problems, raising capital in senior public debt markets, but a similar firm today is able to rely on other sources of financing.
The market for public debt has therefore become much more specialized and increasingly sophisticated over time. After nearly three decades of dealing with high yield debt, investors are better able to understand its performance and risks relative to investment grade debt (bonds rated BBB and above). The decline in covenants reflects a movement away from contractual control of agency problems. If firms are returning frequently to debt markets to issue more public debt, then concerns about their future reputation and the interest rate they will have to pay on their return can be act as an indirect control on their behavior.
Rating agencies play a role in this type of monitoring. Firms that maintain a high debt rating are able to borrow at more attractive interest rates than firms in lower rating categories. Rating agencies monitor firms and adjust ratings downward as default risk increases indicating agency problems of debt have become more severe. Arguably, the incentive to maintain a high debt rating will help to control managements’ incentive to increase the risk of existing debt and this should be more important for firms that frequently return to debt markets for financing. We investigate whether a firm’s frequency of issuing debt can be used to explain the absence of covenants.
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