Essays on debt contracting

Abstract

This thesis consists of three studies that investigate the channels through which corporate governance reforms, choice, and social capital influence contracting in the corporate bond market. In Chapter 1 (solo authored), I examine the public debt contracting consequences of shocks to managerial entrenchment. For identification, I exploit the mandatory adoption of board independence rules under the NYSE and NASD listing requirements as a regulatory reform that enhanced the intensity of CEO monitoring by independent directors. Using a large sample of corporate bond issues, I find that the rules induced economically significant contracting effects in non-compliant firms, namely in the form of lower payout, financing, and event-related covenants as well as higher credit ratings. In further tests, I show that while these effects are not mitigated by shareholder control, they ultimately depend on directors' private incentives and their ability and willingness to engage in costly monitoring. My findings speak to the debate on how equity-centric governance interacts with bondholders' interests and their incentives to impose long-term restrictions on firms' economic activities. Chapter 2 (co-authored with Peter Pope and Ane Tamayo) examines the contracting relevance of the balance sheet in the corporate bond market. Using accounting bloat in net asset values as a proxy for balance sheet quality, we predict and find that aggregate covenant intensity in bond indentures is negatively associated with the quality of issuers' balance sheet numbers. The magnitude of this effect is more pronounced for and event-related covenants and is lower in the case of covenants that restrict payouts, refinancing, and investment activities. Our results are robust to controlling for corporate governance quality and the stringency of monitoring by lenders in syndicated loan deals. Turning to market outcomes, we find that offering yields, credit spreads, and credit ratings are decreasing in balance sheet quality, while the likelihood of agreement among credit rating agencies about new bond issues' credit risk increases with balance sheet quality. To establish a causal link between balance sheet quality and covenant structures, we exploit an exogenous court ruling in Delaware that substantially limits the fiduciary duties of directors to creditors. We show how the legal event affected bond issuers' reporting incentives and altered the debt contracting relevance of their balance sheet numbers. Finally, in Chapter 3 (co-authored with Kalr Lins, Henri Servaes and Ane Tamayo), we investigate whether a firm's capital, and the trust that it engenders, are viewed favourably by bondholders. Using firms' corporate social responsibility (CSR) activities to proxy for social capital, we find no relation between CSR and bond spreads over the 2005-2013 period. However, during the 2008-2009 financial crisis, which represents a shock to trust and default risk, high-CSR firms benefited from lower bond spreads. These effects are more pronounced for firms that, when in distress, have a greater opportunity to engage in asset substitution or divert cash to shareholders. High-CSR firms were also able to raise more debt capital on the primary market during this period, and those high-CSR firms that raised more debt were able to do so at lower at-issue bond spreads, better initial credit ratings, and for longer maturities. Our results suggest that bond investors believe that high-CSR firms are less likely to engage in asset substitution and diversion that would be detrimental to stakeholders, including debtholders. These findings also indicate that the benefits of CSR that accrued to shareholders during the financial crisis carry across to another important asset class, debt capital.