The covenant removal option in corporate bonds

Corporate bonds include restrictive covenants, which may prevent the firm from undertaking valuable growth opportunities ex-post but are virtually impossible to renegotiate. We study a frequently used but little-known provision, the defeasance option, which mitigates this inefficiency by allowing the firm to immediately remove all bond covenants. Our theoretical model predicts, and our large-sample empirical analysis confirms, that financially constrained firms with high uncertainty and bonds with many restrictive covenants are more likely to include this option. Moreover, investors require lower yields for non-callable and make-whole bonds with the defeasance option and higher yields for fixed-price callable bonds.