Bond Covenants Research Articles

Improving Credit Risk Analysis

Many opportunities currently exist to improve credit-risk analysis and add value to fixed-income portfolios. Because the credit markets have grown markedly in recent years and volatility has increased as well, the need for adequate bond covenants has grown commensurately. Credit analysts also must look beyond credit ratings to measure credit risk. The author discusses three ways to measure default probability and explores the use of capital structure convergence as a new tool in credit analysis.

Asset liquidity, capital structure, and secured debt

This paper investigates the impact of asset liquidity on the valuation of corporate securities and the firm's financing decisions. I show that asset liquidity increases debt capacity only when bond covenants restrict the disposition of assets. By contrast, I demonstrate that, with unsecured debt, greater liquidity increases credit spreads on corporate debt and reduces optimal leverage. The model also determines the extent to which pledging assets increases firm value and relates the optimal size of the pledge to firm and industry characteristics. Finally, I show that asset liquidity and security provisions may help explain leverage ratios and credit spreads observed in practice.

Forced Versus Voluntary Dividend Reduction: An Agency Cost Explanation

AbstractWe examine whether the agency cost arising from shareholder‐bondholder conflict is an important determinant of the timing of dividend reduction decisions. Firms forced to reduce dividends owing to bond covenant violations experience lower earnings, more frequent losses, and greater earnings declines around the dividend reduction year than do firms that voluntarily reduce dividends. Relative to voluntary‐reduction firms, forced‐reduction firms have higher debt‐to‐equity ratios and managerial holdings. These findings coupled with the increased dividend payout ratios and lower announcement period returns suggest that financially distressed firms that anticipate poor performance have greater incentives to delay reducing dividends to avoid a wealth transfer to bondholders.

Debt Valuation, Renegotiation, and Optimal Dividend Policy

The valuation of debt and equity, reorganization boundaries, and firm’s optimal dividend policies are studied in a framework where we model strategic interactions between debt holders and equity holders in a game-theoretic setting which can accommodate varying bargaining powers to the two claimants. Two formulations of reorganization are presented: debt-equity swaps and strategic debt service resulting from negotiated debt service reductions. We study the effects of bond covenants on payout policies and distinguish liquidity-induced defaults from strategic defaults. We derive optimal equity issuance and payout policies. The debt capacity of the firm and the optimal capital structure are characterized.

AN INSTITUTIONAL INNOVATION TO REDUCE THE AGENCY COSTS OF PUBLIC CORPORATE BONDS

This paper proposes an institutional innovation in the structure of public bonds that is intended to provide some of the advantages of private loans- active monitoring, tight covenants, and ease of reorganization-while retaining the benefits of liquidity and ease of diversification provided by publicly traded securities. The authors propose that a publicly registered corporate bond provide for a “supertrustee” who will act on behalf of bondholders. The supertrustee will be charged with responsibility to monitor the compliance of the borrower with the terms of the bond covenants and given exclusive authority to negotiate amendments to the covenants and decide what action to take in the event of a breach of a covenant.

A New Governance Structure for Corporate Bonds

This article proposes a new governance structure for publicly issued corporate bonds. Ownership of public bonds is bothfluid and dispersed Fluidity and dispersion generate benefits: They increase the liquidity of public bonds and make their risk more easily diversifiable. By the same token, however, fluidity generates a bonding problem and dispersion generates a collective action problem. In the context of public bonds, these problems increase the agency cost of debt and thus lower the overall value of the company. Private debt, the ownership of which is neither fluid nor dispersed, lacks easy diversification and liquidity, but also entails lower agency cost of debt. The new governance structure Professors Yakov Amihud, Kenneth Garbade, and Marcel Kahan propose is designed to overcome the collective action and bonding problems while retaining the easy diversifiability and liquidity associated with public bonds. The centerpiece of this structure is a new type of bondholder representative, the supertrustee. In contrast to the conventional indenture trustee, the supertrustee will be given the authority and the incentives to monitor the company actively, as well as to enforce and, where appropriate, to renegotiate a bond's covenants on behalf of public bondholders. Because the supertrustee is a single entity, and because the company will have some power over who is appointed as supertrustee, this structure resolves the collective action and bonding problems presently associated with dispersed andfluid ownership of public debt. At the same time, because public bond indentures will contain covenants similar to those presently contained in private debt, agency costs are reduced

Wealth creation versus wealth redistributions in pure stock-for-stock mergers

We examine wealth changes for all 1283 publicly traded debt and equity securities of firms involved in 260 pure stock-for-stock mergers from 1963 to 1996. We find no evidence that conglomerate stock-for-stock mergers create financial synergies or benefit bondholders at stockholders' expense. Instead, we document significant net synergistic gains in nonconglomerate mergers and generally insignificant net gains in conglomerate mergers. Conglomerate bidding-firm stockholders lose; all other securityholders at least break even. Convertible securityholders experience the largest gains, due mostly to their attached option values. Certain bond covenants are value-enhancing while leverage increases are value-reducing.

Restructuring and Organization: Managementʼs Role in Defining Organizational Culture

The lights are on late in evening in executive suite of St. Swizzlestick Hospital as Executive Team meets to consider organization's future. All along, management has recognized that there have been huge shifts in volume of activity, and while pleased with their hospital's competitive position, it was very clear that its main revenue stream-inpatient care-was gradually being diminished. They always knew that future would see fewer people working within organization, and they expected to deal with this lower volume in some thoughtful, deliberative way. Recent financial reports, however, have shaken their belief in more prolonged, leisurely pace at which they anticipated reducing size of organization. In fact, last several months had yielded major losses-something that until Executive Team had yet to face, and something that certainly disappointed trustees. The problem was further compounded when Executive Team recognized that many of managed care contracts they had successfully negotiated, which called for a per diem arrangement, had turned out to be financially disastrous, as length of stay dropped precipitously by as much as 30 percent over last year and a half. The team finally had to realize that economic downturn of hospital was not a temporary phenomenon. Combined with a lesser volume and prejudicial managed care contracts, hospital's revenue, in immediate and long-term future, was likely to be significantly less than anticipated. The team's choices at this late-night session were difficult. It was clear that failure to stop bleeding could have disastrous results. Most obvious was that it would begin quickly to damage hospital's financial ratios, which could possibly call into question its bond covenants and, if unchecked, ultimately weaken its credit worthiness. This would have disastrous long-term results, not only financially but for hospital's image. The truth of adage the future is now sunk home with this group of executives with startling reality. The desperateness of situation caused significant tension in room. It was clear that this group could no longer avoid obvious. While no one wanted to be accused of a knee-jerk reaction, clearly some immediate attention was absolutely necessary. The proposals were quickly and quietly outlined on blackboard. They included such obvious opportunities as limiting travel policy, canceling special events, and reviewing all purchasing decisions. It was quickly realized that monetary effect of these changes fell far short of what was needed to reverse situation. The management team was then faced with fact that in an organization whose expenses are from 50 to 60 percent personnel related, any effective reaction would necessitate a cutback of employees. There, in that executive suite, managers came face-to-face with most dreaded decision that employers must make, particularly if they have a sincere regard and affection for their employees. The future viability of organization was very much in question, and failure to act would have longterm consequences. Yet realization that a significant number of employees could be cut back was a very unhappy thought. This scenario is being repeated in executive suites of hospitals and healthcare systems across this country. In some cases warning signs were present for years and management simply failed to acknowledge or address them. In other cases, financial fortunes reversed much quicker, and while it was always management's intent to deal with issue, it was caught off guard with rapidity with which financial situation deteriorated. In either case, need for action is evident. Downsizing, Reengineering, and Restructuring: Long-Term Implications for Healthcare Organizations deals analytically with elements involved in reducing labor costs and reviews most recent literature and experiences researchers have had with these cost-cutting tools. …

The Cost of Bond Covenant Restrictions on the Disposition of Assets

The cost of bond covenants restricting the dispositions of assets are examined in this study. Using an option pricing framework, it is shown that the cost of compliance could be high if restrictions are placed on the sale of common stock holdings. Similar results can be obtained by using a simple cash flow approach when calculating the effect on restrictions on the sale of depreciable assets. These costs somewhat offset the tax advantages of debt.

Corporate bond maturity decision: an agency and transaction cost explanation

It is argued that firms make the choice of the term to maturity of a new corporate bond issue so as to minimize the aggregate of the agency costs and transaction costs. Issuing bonds with longer terms to maturity will allow firms to reduce the transaction costs associated with bond issues. However, the longer the term to maturity, the higher the agency costs associated with the issue. It is hypothesized that high agency costs associated with both the longer maturities and the default risk of a bond issue will force firms at high risk of default to issue short- or medium-term bonds. Bond covenants such as convertibility, the call provision, the sinking fund provision, and the put provision reduce agency costs of a bond issue. Therefore, firms at high risk of default will make use of such bond covenants to increase the term to maturity of a bond issue and consequently reduce the aggregate of the agency costs and transaction costs associated with debt. Firms with low default risk will be more flexible regard...

071070 (E31, E50, B70, B30) The underinvestment problem, bond covenants, and insurance : Garven J.R., MacMinn R.D., University of Texas at Austin, The Journal of Risk and Insurance, vol. 60, nr. 4, 1993, pp. 635–646

071070 (E31, E50, B70, B30) The underinvestment problem, bond covenants, and insurance : Garven J.R., MacMinn R.D., University of Texas at Austin, The Journal of Risk and Insurance, vol. 60, nr. 4, 1993, pp. 635–646

Corporate Debt Value, Bond Covenants, and Optimal Capital Structure

ABSTRACTThis article examines corporate debt values and capital structure in a unified analytical framework. It derives closed‐form results for the value of long‐term risky debt and yield spreads, and for optimal capital structure, when firm asset value follows a diffusion process with constant volatility. Debt values and optimal leverage are explicitly linked to firm risk, taxes, bankruptcy costs, risk‐free interest rates, payout rates, and bond covenants. The results elucidate the different behavior of junk bonds versus investment‐grade bonds, and aspects of asset substitution, debt repurchase, and debt renegotiation.

Corporate Debt Value, Bond Covenants, and Optimal Capital Structure

This paper examines corporate debt values and capital structure in a unified analytical framework. It derives closed form results for the value of long-term risky debt and yield spreads, and for optimal capital structure, when firm asset value follows a diffusion process with constant volatility. Debt values and optimal leverage are explicitly linked to firm risk, taxes, bankruptcy costs, riskfree interest rates, payout rates, and bond covenants. The results elucidate the different behavior of junk bonds vs. investment grade bonds, and aspects of asset substitution, debt repurchase, and debt renegotiation.

An Empirical Examination of Dividend Policy Following Debt Issues

This paper empirically examines the underinvestment problem and the use of dividends to expropriate lenders' wealth. Rather than analyzing the market's reaction to potential wealthexpropriating events, a different aspect of potential conflicts of interest is addressed: do managers who control dividends act in a manner consistent with wealth expropriation? If so, then debt issues should be followed by increases in dividends. Two samples of firms are used: those issuing straight debt and those issuing convertible debt. The study finds no evidence that firms manipulate dividend policy to transfer wealth from the bondholders to stockholders. Two possible explanations are suggested. First, wealth expropriation may be a potential problem, but existing bond covenants restricting a firm's ability to pay dividends are effective. Second, firms may believe that reputation has greater value than what can be transferred from creditors in a one-time expropriation of wealth. Since the paper fails to find support for the covenant argument, it concludes that reputation is the most plausible explanation.

Event Risk Bond Covenants, Agency Costs of Debt and Equity, and Stockholder Wealth

We examine the effect of risk covenants in bond indentures on agency costs of debt and equity and stockholder wealth by testing two competing hypotheses for issuing event risk-protected bonds: the stockholder wealth enhancement hypothesis and the managerial entrenchment hypothesis. We find that the issuance of event risk-protected bonds has a more positive impact on stockholder wealth than the issuance of non-protected bonds. Regression analysis indicates that more positive stockholder gains are associated with firms characterized by higher agency costs of debt. These findings suggest that the presence of event risk covenants increases stockholder wealth primarily by lowering a firm's agency costs of debt.

The Underinvestment Problem, Bond Covenants, and Insurance

Introduction underinvestment problem has been well known in finance since the appearance of Myers's (1977) seminal work on The Determinants of Borrowing. Myers considers a situation in which the firm has an outstanding bond issue now and may invest in a positive net present value project then.(1) payoff on the investment project is risky now but not when the decision is made then. underinvestment occurs because there are realized project payoffs that cover the investment expenditure then but not the investment expenditure and the promised payment on the bond issue. If the firm did invest in the project under these circumstances, then all net proceeds would go to bondholders. Hence, management that acts in the best interests of its shareholders never makes such an investment decision. Given rational expectations, the stock market value of the firm is larger now because of management's decision then not to invest under the conditions just described. Mayers and Smith (1987) article, Corporate Insurance and the Underinvestment Problem, builds on Myers's work. Mayers and Smith have provided an interesting and intuitively appealing discussion of the role played by insurance in bonding the corporate investment decision. Schnabel and Roumi (1989) have extended the model proposed by Mayers and Smith to a consideration of the effect of a safety, or premium loading. Although Mayers and Smith assert that the gains associated with resolving the underinvestment problem are enjoyed by shareholders, their analysis does not explicitly provide the mechanism to show how this is accomplished.(2) This article provides two routes out of this difficulty. Because the Mayers and Smith and Schnabel and Roumi models do not allow the promised debt payment to change after insurance is introduced, it follows that the debt issue raises more money with the insurance covenant than without it. Hence, current shareholders get the additional value if the manager sets a payment now equal to the difference between the debt values with and without the insurance covenant net of the insurance premium. We will refer to this later as the cum dividend interpretation of the Mayers and Smith and Schnabel and Roumi models. However, rather than confound financing and decisions unnecessarily, we propose an alternative solution that requires the imposition of a financing condition. This allows us to show that an insurance deductible may be chosen that enables the manager to also reduce the promised debt payment and restore full value for the current shareholders. Our analysis explicitly shows that an insurance covenant can be designed that allows current shareholders to capture the gain in value and that the gain in value equals the agency cost of the underinvestment problem. We believe that the introduction of a financing condition rather than a policy is more instructive, since it allows us to focus more neatly on the structure of the bond/insurance financing package. This difference becomes particularly important when premium loading is introduced, because the ability to adjust the promised debt payment allows the manager to reduce the cost due to premium loading. Underinvestment Problem Although limited liability confers a number of important economic benefits, it also has its costs (see Easterbrook and Fischel, 1985). By creating an asymmetry between the costs and benefits of risky activities, limited liability causes bondholders and shareholders to have incompatible incentives whenever the corporation's debt is subject to the risk of bankruptcy. Mayers and Smith identify a situation in which the conflict of interests is so severe that an underinvestment problem occurs. In their model, underinvestment occurs in the sense that shareholders choose to forego a positive net present value investment that, in the absence of bankruptcy risk, would be undertaken. In order to focus their analysis on the role of insurance in resolving this problem, Mayers and Smith assume that the only source of uncertainty for the firm is whether it will suffer a property loss. …

Do Bondholders Lose from Junk Bond Covenant Changes?

This article documents that firms can and do change the covenants of their public debt indentures through consent solicitations. A game-theoretic model shows that bondholders may consent to covenant changes even when it is not in their collective interest to do so. Despite this finding, bondholder returns around solicitations are positive. Further analysis indicates that bondholders coordinate their actions to modify or defeat disadvantageous proposals and, therefore, can demand some of the gains resulting from covenant modifications. The policy implication of this study is that bondholders may not need additional regulatory or judicial protection in the solicitation process. Copyright 1993 by University of Chicago Press.

Bond Covenants and Forgone Opportunities: The Case of Burlington Northern Railroad Company

In 1896, J.P. Morgan and the Deutsche Bank developed a reorganization plan for Northern Pacific Railroad that included the issuance of $181.6 million of bonds with very restrictive covenants. Years later, Burlington Northern Railroad Company, which had assumed the Northern Pacific bonds, attempted to get around those restrictions. However, the indentures of the two series of bonds withstood the attacks of presumably clever bond lawyers. In 1987, Burlington Northern Railroad agreed to pay bondholders $35.5 million plus court costs to relax the covenants. This case provides an interesting illustration of one of the agency costs of bond covenants - forgone opportunities. While the payment to the bondholders amounted to 30% of the face value of the bonds, the gain to shareholders amounted to about $475 million in the form of abnormal returns.

Event Risk: An Analysis of Losses to Bondholders and "Super Poison Put" Bond Covenants

Ten percent of the investment-grade industrial bonds that were associated with major capital restructurings between 1-983 and 1988 had already been downgraded to speculative grade as of August 1989. In response to these downgrades, and the corresponding wealth losses for bondholders, over 40 percent of recently issued investment-grade industrial bonds are protected from this type of by virtue of specialized covenants. These event-risk convenants may have initially reduced interest costs for borrowers by roughly 20 to 30 basis points. However, the magnitude of the effect appears to have declined along with the general decline in corporate restructurings. THE WAVE OF CORPORATE restructurings in the 1980s' and the accompanying expansion of debt gave rise to a marked deterioration in credit quality in the corporate bond market. The financing of the restructurings typically included new debt with a priority equal to or higher than that of the firm's outstanding bonds. As a result of the increase in risk, billions of dollars in outstanding bonds were downgraded from investment grade to speculative grade.' In the process, investors became increasingly concerned with event risk-the risk of a substantial decline in the market price of a firm's outstanding bonds arising from an unforeseen and major change in its capital structure. Since late 1988, several corporate bond offerings have included event-risk covenants as a safeguard against leverage-induced losses. Most of the covenants are ''super poison puts, which give investors the right to sell their bonds back to the issuer at par in the event of a leveraged restructuring and subsequent downgrading to speculative grade.

Event Risk: An Analysis of Losses to Bondholders and “Super Poison Put” Bond Covenants

ABSTRACTTen percent of the investment‐grade industrial bonds that were associated with major capital restructurings between 1983 and 1988 had already been downgraded to speculative grade as of August 1989. In response to these downgrades, and the corresponding wealth losses for bondholders, over 40 percent of recently issued investment‐grade industrial bonds are protected from this type of “event risk” by virtue of specialized covenants. These event‐risk convenants may have initially reduced interest costs for borrowers by roughly 20 to 30 basis points. However, the magnitude of the effect appears to have declined along with the general decline in corporate restructurings.