Debt Covenants and the Speed of Capital Structure Adjustment

Abstract

This paper examines the impact of debt covenants on the speed of capital structure adjustment. Overall, we find that covenants lower the speed of adjustment by 10–13%, relative to the speed of adjustment of firms without covenants. The speed of adjustment is significantly lower, by 40–50%, for firms with the most intense covenant provisions. In particular, we find that capital covenants, as opposed to performance covenants, appear to be the main mechanism that lowers the speed of adjustment, delaying the speed of capital structure adjustment by 86%. We find that the speed of adjustment is reduced more for strict capital covenants than for strict performance covenants. We also show that, for firms that are cash and financially constrained, covenants impede the speed of adjustment even more. Lastly, we show that the negative relationship between covenants and the speed of adjustment is more pronounced for firms that are over-levered.