Corporate Refinancing, Covenants, and the Agency Cost of Debt

How valuable are restrictive debt covenants in reducing the agency costs of debt? I answer this question by exploiting the revealed preference decision to refinance fixed-coupon debt, which weighs observable interest rate savings against the unobservable costs of a change in restrictive debt covenants induced by refinancing. Plausibly exogenous variation in this trade-off reveals that firms require higher interest rate savings to refinance when it would add restrictive covenants and require much lower interest rate savings when refinancing sheds covenants. I structurally estimate a dynamic model of debt refinancing and covenants to match these patterns, which reveals the agency costs of debt solved by covenants. A high-yield bond’s restrictive covenant package increases the value of speculative-grade firms by 2.4 percent on average. This is a large fraction of estimates in the literature of the net benefits of debt, suggesting the contracting refinements covenants add to debt are essential for allowing the tax benefits of debt to offset costs of financial distress. Massachusetts Institute of Technology, Sloan School of Management. Contact: [email protected] This paper owes a tremendous debt to my thesis advisor Jonathan Parker for his enthusiasm and dedication, and to my committee members, Nittai Bergman, Hui Chen, and Andrey Malenko, for their support and guidance. I am also grateful to Paul Asquith, Vivek Bhattacharya, Simon Gervais, Adam Jørring, Paymon Khorrami, Jack Liebersohn, Ernest Liu, Erik Loualiche, Scott Nelson, Anton Petukhov, Antoinette Schoar, Ludwig Straub, and David Thesmar for helpful comments. The Becker Friedman Institute’s Macro Financial Modeling Initiative provided financial support for this project.