Academic journal article Journal of International Business Research

The Determinants of Accounting-Based Covenants in Public Debt Contracts

Academic journal article Journal of International Business Research

The Determinants of Accounting-Based Covenants in Public Debt Contracts

Article excerpt


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. Using a public, non-convertible bond sample from Japan, I conducted an empirical analysis to identify such determinants.

The remainder of this paper is organized as follows: Section 2 reviews the literature on the determinants of setting covenants; section 3 explains the expected relationship between the determinants and setting covenants on the basis of previous research; section 4 introduces the sample; section 5 shows the research design; section 6 presents empirical results; and, section 7 provides a summary and conclusion.


In this section, I will introduce some earlier research that supports this paper. Previous research has focused on the determinants for the setting of debt covenants in private lending contracts and/or public bond contracts. Firms incur public debt by issuing bonds. Public bonds tend to be long-term, with relatively loose covenants, they are monitored by a trustee and there is limited flexibility for renegotiating the contract. By contrast, private loans are mostly obtained from banks, tend to be of shorter durations, have extensive covenants, and are renegotiable (Ronen & Yaari, 2008). …

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