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Uncertainty and debt covenants

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  • Peter R. Demerjian

    (University of Washington)

Abstract

I examine the use of financial covenants when contracting for debt under uncertainty. Uncertainty, in the context of this study, is a lack of information about future economic events and their consequences for the borrower’s creditworthiness. I examine the implications of ex ante uncertainty that is resolved by information received following loan initiation but prior to maturity. I argue that financial covenants, by transferring control rights ex post, provide a trigger for creditor-initiated renegotiation when the borrower is revealed to be of low credit quality. Using a large sample of private loans, I predict and find that financial covenant intensity is associated with greater uncertainty. I also revisit the agency-based explanation for covenant use and find that this uncertainty explanation is robust to various controls for agency conflicts.

Suggested Citation

  • Peter R. Demerjian, 2017. "Uncertainty and debt covenants," Review of Accounting Studies, Springer, vol. 22(3), pages 1156-1197, September.
    • Handle: RePEc:spr:reaccs:v:22:y:2017:i:3:d:10.1007_s11142-017-9409-z
    DOI: 10.1007/s11142-017-9409-z
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    More about this item

    Keywords

    Debt covenants; Uncertainty; Debt contracting; Agency theory;
    All these keywords.

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G30 - Financial Economics - - Corporate Finance and Governance - - - General
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting

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