The Determinants of Accounting-Based Covenants in Public Debt Contracts

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ABSTRACT

According to the Agency Theory of Covenants, debt contracts play a significant role in the context of stockholder-bondholder conflicts. Much research has been devoted to examining the determinants of the content of debt contracts on the basis of this theory. However, little research has been conducted in a Japanese context. Using a public non-convertible bond sample from Japan, I examined the setting of accounting-based covenants and identified some determinants. When the maturity of a bond is long and the issuer is large, bondholders are less likely to include accounting-based covenants. By contrast, when there is a bond manager and the issuer's leverage ratio is high, bondholders are likely to include accounting-based covenants. In addition, I found that an alternative relationship exists between the setting of accounting-based covenants and interest rates after controlling for the simultaneous relationship between them. That is, to protect themselves, bondholders will either include accounting-based covenants or higher interest rates.

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

Jensen and Meckling (1976), Myers (1977), and Smith and Warner (1979) developed the Agency Theory of Covenants, which provides a rationale for the presence of covenants in debt contracts (Bradley & Roberts, 2004). A covenant is a provision, such as a limitation on the payment of dividends, which restricts the firm from engaging in specified actions after the bonds are sold (Smith & Warner, 1979). The main idea of the Agency Theory of Covenants is the conflict of interests that exist between stockholders and bondholders: Given that stockholders can force managers to take action on their behalf after the debt contract (between the firm and bondholders) has been created, managers can take action in areas such as overinvestment, underinvestment, asset substitution, claim dilution (i.e., more debt finances), and excessive dividends that result in a wealth transfer from bondholders to stockholders. Therefore, bondholders use debt contracts ex ante to protect themselves. By including covenants in the debt contracts, and thereby restricting managers' activities, bondholders can protect their interests. However, including covenants in a debt contract restricts a firm's activities and often generates opportunity costs. For example, including covenants that restrict a firm's financial activities may be costly for high-growth firms. Although high-growth firms have more investment opportunities, they may not be able to sufficiently finance their investments with positive net present values because of such covenants. Such constraints may result in a firm being unable to maximize its value. Therefore, it is useful for managers to understand what factors bondholders consider when deciding whether or not to include some kind of covenants in their debt contracts.

If certain covenants will prevent maximization of a firm's value, bondholders may not want to use such covenants. If covenants are not included in debt contracts, an alternative would be to set a high interest rate ex ante as a way for bondholders to protect their interests. Bondholders can, therefore, decide which path to take-covenants or interest rates-when making contracts, and their use is probably made simultaneously. When we examine the determinants of debt covenant use, we should take this relationship into account.

On the basis of the concepts explained above, I examined the determinants involved in the setting of accounting-based covenants, which specify accounting numbers. For example, a net worth covenant requires the borrower to maintain a specified minimum net worth. This covenant is included in the debt contract to maintain the net worth that would be used for full debt repayment. Accounting-based covenants restrict accounting numbers, so they have a large influence on a firm's activities. Therefore, it is meaningful for us to consider the determinants of accounting-based covenants. …