Restrictive Covenants Included in Public Debt Agreements: An Empirical Investigation

Abstract

The contracting literature suggests restrictive debt covenants are part of the firm's set of optimal contracts designed to control agency problems between debt and equity holders. This study presents evidence in support of such an assertion. Companies that are expected to face higher agency costs of debt are more likely to include covenants restricting dividends, financing and investment, in their debt issues. While this is true for the non-subordinated (senior) debt issues in the sample, it does not hold among subordinated issues. Firms issuing subordinated debt face more growth opportunities and are more likely to go bankrupt, than their senior debt counterparts. However subordinated issues do not include more covenants. The frequencies of dividend covenants and covenants requiring the maintenance of insurance, properties and the corporate existence are similar in senior and subordinated debt issues. But other covenants used frequently in senior debt issues: restrictions on additional borrowing, on investments in securities and on the disposal of subsidiaries, almost never appear in subordinated issues. The absence of these covenants in subordinated debt issues is consistent with these covenants being more costly to the types of firms that issue subordinated debt.