The Structure and Pricing of Corporate Debt Covenants

We provide evidence on the covenant structure of corporate loan agreements. Building on the work of Jensen and Meckling [1976, Theory of the Firm: Managerial Behavior, Agency Costs, and Captial Structure,Journal of the Financial Economics3, 305–360], Myers [1977, Determinants of Corporate Borrowing,Journal of Financial Economics5, 145–147] and Smith and Warner [1979, On Financial Contracting: An Analysis of Bond Covenants,Journal of Financial Economics7(2), 117–161]. We summarize and test the implications for what we refer to as the Agency Theory of Covenants (ATC), using a large sample of privately placed corporate debt. Our results are consistent with many of the implications of the ATC, including a negative relation between the promised yield on corporate debt and the presence of covenants. We also find that borrower and lender characteristics, as well as macroeconomic factors, determine covenant structure. Loans are more likely to include protective covenants when the borrower is small, has high growth opportunities or is highly levered. Loans made by investment banks and syndicated loans are also more likely to include protective covenants, as are loans made during recessionary periods or when credit spreads are large. Finally, we show that consistent with the ATC, firms that elect to issue private rather than public debt are smaller, have greater growth opportunities, less long-term debt, fewer tangible assets, more volatile cash flows and include more covenants in their debt agreements. An important byproduct of our analysis is to demonstrate empirically that covenant structure and the yield on corporate debt are determined simultaneously.