Debt Covenants and Bankruptcy Risk

Abstract

Riskier firms use more covenants, yet effective covenants should reduce the probability of bankruptcy by restricting management’s actions. We disentangle these two relations between covenant use and bankruptcy risk by considering predicted and actual covenant use. We find that predicted covenant use is associated with a higher probability of bankruptcy and shorter firm survival, whereas actual covenant use is associated with a lower probability of bankruptcy and longer firm survival. This evidence is consistent with the notion that the use of covenants reduces bankruptcy risk. However, theory suggests that two covenants -- stock issuance restrictions and rating decline puts -- do not reduce the probability of bankruptcy. Empirically, we find that the use of either of these covenants implies a higher probability of bankruptcy and a shorter survival time. On the cost side, we find evidence that corporate bonds with more restrictive covenants have higher issuance costs. While we find some evidence that bonds with more covenants are more difficult to sell, we argue that this covenant-issue cost relation is mainly driven by the risk to underwriters. Overall, these results both confirm some essential aspects of, and expand upon, Smith and Warner’s (1979) costly contracting hypothesis.