Abstract
AbstractI provide evidence that covenants in bond indentures affect firms’ investment policies outside of covenant violations. After controlling for the self‐selectivity of covenant inclusion, I find that firms decrease (increase) capital expenditure after issuing bonds with investment (financing) restrictions. Firms that are more financially constrained or overinvesting are the most affected by investment restrictions, whereas only underinvesting firms see a positive effect from financing restrictions. My results provide empirical evidence that bond covenants help mitigate agency problems related to investment distortions, and especially that covenants restricting financing activities can alleviate the underinvestment problem.
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