A covenant is a particular clause in a firm’s debt contract that restricts the firm’s options and provides creditors with the right to enforce certain actions (e.g., early repayment) if the covenant is violated. According to the agency theory of cove-nants, if the benefits of implementing a covenant exceed the costs, then lenders will include covenants in their debt contracts. We investigate a new aspect of the dis-cussion on covenants, namely, the tightness of a covenant. We provide a theoretical model of the optimal threshold for covenants in public and private debt agree-ments. We found a negative relationship between the costs of covenant violations and covenant strictness. Using a reduced form of the model, we find that the posi-tive difference between public and private debt covenant thresholds holds only: (i) for less risky firms, (ii) for lower coordinated bondholders, and (iii) for lower rene-gotiation costs for the bank compared to those of the bondholders.

The covenant threshold in public and private debt

Bazzana, Flavio;Broccardo, Eleonora
2013

Abstract

A covenant is a particular clause in a firm’s debt contract that restricts the firm’s options and provides creditors with the right to enforce certain actions (e.g., early repayment) if the covenant is violated. According to the agency theory of cove-nants, if the benefits of implementing a covenant exceed the costs, then lenders will include covenants in their debt contracts. We investigate a new aspect of the dis-cussion on covenants, namely, the tightness of a covenant. We provide a theoretical model of the optimal threshold for covenants in public and private debt agree-ments. We found a negative relationship between the costs of covenant violations and covenant strictness. Using a reduced form of the model, we find that the posi-tive difference between public and private debt covenant thresholds holds only: (i) for less risky firms, (ii) for lower coordinated bondholders, and (iii) for lower rene-gotiation costs for the bank compared to those of the bondholders.
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Bazzana, Flavio; Broccardo, Eleonora
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Utilizza questo identificativo per citare o creare un link a questo documento: http://hdl.handle.net/11572/97039
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