Bond Covenants and Investment Policy

Abstract

I provide evidence that covenants in bond indentures affect the firm's investment policy outside of covenant violations. Using a large dataset of public bonds, and controlling for the self-selectivity of covenant inclusion, I find that bonds with investment (financing) restrictions are associated with a decrease (increase) in investment in the two years following the issue. The effect of investment restrictions is entirely driven by firms that are more financially constrained. Both financially constrained and unconstrained firms have significantly higher investment spending after issuing a bond with financing restrictions, although the magnitude of the effect is higher in the latter group. These findings suggest that while bond covenants can help mitigate agency problems and reduce the cost of debt, they may also have externalities that lead to more investment distortions in firms that are closer to financial distress. This paper is the first to document a positive relationship between a covenant restriction and ex-post investment.