Debt heterogeneity and covenants

• Main Authors: LOU, Yun, OTTO, Clemens A.
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2018
• Subjects: Debt Heterogeneity; Debt Covenants; Creditor Conflicts; Coordination Failure; Corporate Finance; Finance and Financial Management
• Online Access: https://ink.library.smu.edu.sg/soa_research/1754; https://ink.library.smu.edu.sg/context/soa_research/article/2781/viewcontent/SSRN_id2297804.pdf
• Institution: Singapore Management University

Coordination failure among owners of heterogeneous debt types increases distress costs. Covenants reduce expected distress costs by lowering the probability of liquidity shortages, increasing liquidation values, and incentivizing creditor monitoring. We predict and find that new debt contracts include more covenants when borrowers' existing debt structures are more heterogeneous. Our findings suggest that covenants are not only used to address creditor-shareholder conflicts but also to reduce the expected costs of coordination failure among creditors. Further, our results indicate a dynamic component missing from static debt structure models: Debt heterogeneity entails additional covenants (i.e., constraints) when raising future debt.