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Debt Heterogeneity and Covenants

Author

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  • Yun Lou

    (School of Accountancy, Singapore Management University, Singapore 178900;)

  • Clemens A. Otto

    (Lee Kong Chian School of Business, Singapore Management University, Singapore 178899)

Abstract

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. Furthermore, our results indicate a dynamic component missing from static debt structure models: Debt heterogeneity entails additional covenants (i.e., constraints) when raising future debt.

Suggested Citation

  • Yun Lou & Clemens A. Otto, 2020. "Debt Heterogeneity and Covenants," Management Science, INFORMS, vol. 66(1), pages 70-92, January.
  • Handle: RePEc:inm:ormnsc:v:66:y:2020:i:1:p:70-92
    DOI: 10.1287/mnsc.2018.3141
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