Creditor Dispersion and Debt Covenants

Abstract

Coordination failure among the owners of heterogeneous debt types can increase expected distress costs. Covenants can help reduce these costs by lowering the probability of liquidity defaults. We show that loans are indeed subject to more covenants when the borrowers' debt structures are more heterogeneous. Our findings suggest that covenants are used to reduce not only creditor-shareholder conflicts but also the expected costs of coordination failure among creditors holding different types of debt. Further, our results indicate a dynamic component missing from static debt structure models: Debt heterogeneity leads to additional covenants (i.e., constraints) when raising future debt.