Debt Covenant Violation and Cost of Borrowing: Evidence from Quarterly Bond Issue

Abstract

Do debt covenant violations increase the cost of borrowing for violating firms? By examining the SEC filing of and bond issue by all US nonfinancial firms from 1996 to 2005, I find that debt covenant violations play an important role in determining the cost of debt for firms. The results indicate that debt covenant violations are important from three aspects: the incidence of violation, the timing of the violation and the frequency of the violation. The results outline these three aspects. First, I find that violating firms on average have a higher cost of borrowing (100 to 107 bps) compared to non-violators. Second, I find that firms which report a violation in the bond-issue quarter have a higher cost of borrowing (30 to 44 bps) compared to firms that did not report a violation and firms that report a debt covenant violation in the quarter preceding the bond-issue report a higher cost of borrowing (88 to 105 bps) compared to non-violators. Third, I find that firms that report exactly one debt covenant violation have a higher cost of borrowing (13-47 bps) than non-violating firms, although the increase is not significant. I also find that firms that report more than one debt covenant violation have a higher cost of borrowing (39-48 bps) than non-violating firms. I conclude that there are significant benefits of not violating a debt covenant and violators are penalized by the creditors for not upholding the contractual restrictions.