The Covenant Threshold in Public and Private Debt

Abstract

A covenant is a particular clause in a firm's debt contract that restricts the firm'soptions and provides creditors with the right to enforce certain actions (e.g., earlyrepayment) if the covenant is violated. According to the agency theory of covenants,if the benefits of implementing a covenant exceed the costs, then lenders will includecovenants in their debt contracts. We investigate a new aspect of the discussion oncovenants, namely, the tightness of a covenant. We provide a theoretical model of theoptimal threshold for covenants in public and private debt agreements. We found anegative relationship between the costs of covenant violations and covenant strictness.Using a reduced form of the model, we find that the positive difference betweenpublic and private debt covenant thresholds holds only: i) for less risky firms,ii) for lower coordinated bondholders, and iii) for lower renegotiation costs for thebank compared to those of the bondholders.