Academic journal article Academy of Accounting and Financial Studies Journal

Debt Covenant Selection: An Empirical Examination

Academic journal article Academy of Accounting and Financial Studies Journal

Debt Covenant Selection: An Empirical Examination

Article excerpt


How are debt covenants selected? Which firm and industry factors are significant in the covenant selection process? Previous research by the current authors examined individual debt covenants to determine if identifiable patterns exist and if there is a significant difference in debt covenant utilization among industry classifications. The evidence suggested that not only are there identifiable patterns, but that debt covenants are systematically grouped into packages. A theory of debt covenant utilization was offered to explain the theoretical significance of each of the independent variables that appear to influence selection. This paper offers additional insight. It develops a model to test the significance of the independent variables and the patterns and predictability of use. After identifying the significant variables, the authors explain the implications of their findings to current financial management.


Equity investors enjoyed years of a bull market from 1982 to early 2000, when the value of U. S. common stocks peaked at approximately $17 trillion in market value of the Wilshire 5000 index. The stock market slide began in the year 2000, and this downward trend continued in the days following the September 11, 2001 terrorist attacks on the United States' homeland. Throughout 2002, as equity markets struggled to stage several comeback rallies, the market's bad news shifted to huge business failures and bankruptcies, due to deceit and outright fraud in Fortune 100 companies such as Enron, Tyco, and Worldcom. The Wilshire 5000 index further declined during 2002 to end the year at a market value of only about $10 trillion, a stunning paper loss approximating $7 trillion over the three year period (Browning, 2003). Indeed, investor confidence in equities has deteriorated so much, that one major Canadian investment broker recently stated that "investors have totally lost faith in the stock market" (Wahl, 2002).

For many of these stock-shy investors, both corporate and individuals, investing in corporate bonds is becoming an increasingly attractive alternative, despite historically low interest rates. The increased attractiveness of bonds is due not only to the recent volatility of equity markets, but also to the reduced transactions costs and increased liquidity of corporate bonds for individual investors. Previously, corporate bond issues were funneled through only a few Wall Street dealers, resulting in bond prices being controlled by this small group. In recent years, more bonds are being issued in smaller increments without substantially increasing transactions costs, thus making them more attractive to individual purchasers. Additionally, research and analysis on thousands of bond issues has recently become available to the investing public on the Internet (Updegrave, 2001). The combined result of these factors is that non-institutional bond investors can buy investment grade corporate bond issues more easily and at more competitive prices than before.

With many investors fleeing equity markets seeking to preserve their investment capital, perceived risk will be a critical factor in bond selection. Spurned equity investors are likely to examine bond covenants more now than at any other time in recent decades. In addition to the usual decisions made with new debt offerings, financial managers may need to be particularly attentive to bond covenant selection. While they may be more important to investors still reeling from equity portfolio shrinkage and corporate fraud scandals, covenants can be quite costly to issuers. The challenge to management will be to include only those covenants which are necessary to make the issue marketable, and no more. The number and characteristics of the necessary covenants will vary considerably by issuer and by issue at any given point in time.

This study provides insight into debt covenant selection for financial managers of companies considering new debt offerings. …

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