BOND COVENANTS, BOND ISSUE SIZE, AND CREDIT DEFAULT SPERED PREMIUMS

Abstract

My dissertation contains two essays. It discusses the role of bond covenants in modern capital market and how they impact firms’ financial activities. Bond covenants are effective mechanism to mitigate the agency problems between bondholders and bond issuers. The design of bond covenants has extensive influence on firms’ financial activities. The first essay examines the effect of bond covenants on issue size. The agency problems can prevent bondholders from lending fund to issuers. The inclusion of bond covenants in indenture can provide bondholder with protection by restricting issuers’ activities, indicating the potential relationship between bond issue size and covenants. My findings suggest that restrictiveness of bond covenants is positively related with the issue size. Due to different agency problem, the design of bond covenant put emphasis on different restriction covenant. As a result, the essay observes that for investment grade (below grade) issuers issue size is positively related with the restrictiveness of financing (investment) covenants. Meanwhile due to the severe agency problem in low quality issuers, low rating firms have to include more covenants to raise the same amount of capital. The findings in the first essay indicate that firms can sacrifice their management by including restrictive covenants to raise more capital. The second essay examines the effect of bond covenants on likelihood of CDS issuance and the level of CDS spreads. Like bond covenants, CDS contracts are also effective mechanism to mitigate the agency problem between bondholders and bond issuers. The issuance of CDS occurs after firms include bond covenants, indicating that one of reasons for CDS is bondholders’ feeling of insecurity due to the unrestrictive bond covenants. My findings indicate that the restrictiveness of bond covenant can affect the likelihood of CDS issuance. CDS serves as complement to bond covenants for investment grade bondholder to mitigate the agency problem by providing bondholder with extra protection in the case of default. At the same time, bond covenant can also influence the level of CDS spreads by influencing the issuers’ default risk because actual use of bond covenants can lower the default risk. My findings suggest the level of CDS spread is negatively related with the restrictiveness of bond covenants. The findings in essay 2 not only provide possible reasons for CDS issuance and an important factor influencing the level of CDS spread but also build a link between literature of bond covenants and CDS.