Corporate Refinancing, Covenants, and the Agency Cost of Debt

Format:Print
| Language:English

Abstract

How valuable are restrictive debt covenants in reducing the agency costs of debt? I exploit the revealed preference decision to refinance fixed-coupon bonds, which weighs observable interest rate savings against the unobservable costs of a change in restrictive covenants. Variation in this trade-off reveals that firms require higher interest rate savings to refinance when it would add restrictive covenants. I structurally estimate a model of debt refinancing and find that a high-yield bond's restrictive covenant package increases the value of speculative-grade firms by 2.4 percent. This suggests that covenants are essential for allowing the tax benefits of debt to offset costs of financial distress.