Price Uncertainty and Debt Covenants

Abstract

I use a forward-looking and exogenous measure of price uncertainty to examine the causative effect of uncertainty on the choice and use of financial covenants in private and public debt contracts, as well as the role that risk management and financial frictions play in that relationship. In private loans, high uncertainty leads to more and tighter financial covenants linked to performance. Risk management attenuates the effect of uncertainty on the inclusion of financial covenants while firms characteristics especially related to default risk intensify the effect. In bond contracts, uncertainty decreases the use of financial covenants for firms that have financial covenants in an existing private loan at the time the bond is issued. These results are consistent with the theory that financial covenants help lenders economize on monitoring costs and suggest that bondholders economize on monitoring costs by free-riding on the monitoring efforts of private lenders.