Covenants and Collateral in Japanese Corporate Straight Bonds: Choice and Yield Spread

Abstract

How does a firm choose a set of covenants and of collateral to pledge when issuing straight bonds publicly in Japan? Covenants and collaterals are contract clauses intended to protect rights of the bondholders. If the protection is priced in the issue, why do firms try to put them all in the issue? Taking it into account that we only observe data for a covenant-collateral type chosen by firms, we estimate a relation between issue prices (yield spreads) and credit risk factors. We obtained a distinct relationship for each covenant-collateral type. We conduct two-step estimates of a Heckman type. In the first step we estimate multinomial logit models of covenant-collateral choice, and found supports for the physical cost hypothesis, the hysteresis hypothesis, and signaling hypothesis. Most notably, however, we found that strategic default concerns involve direct costs in the choice, not through indirect effects on the yield spread.