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The Role of Covenants in Public and Private Debt

Covenants are particular clauses in debt contracts of firms that restrict business policy, giving creditors the possibility of putting precise actions into force - normally early repayment - when the covenants are violated. We refer to the Agency Theory of Covenant (ATC), which assumes that as long as the offsetting benefits exceeds the costs of the constraints imposed by the covenants, the lender will include covenants in their debt contracts. The goal of this paper is to provide a theoretical model that explains the empirical findings of research on public (bonds) and private (bank loans) debt, by highlighting the role of coordination costs among debtholders. Our study introduces two innovative aspects to the existing literature: (1) an emphasis on the covenant violation costs, and (2) the formalisation of a market equilibrium approach. In particular, we formalise the renegotiation costs of the lender, and we identify the effect of the degree of coordination on the renegotiation costs and, ultimately, on the efficiencies in the use of covenants. With regard to, the second point, as far as we know, our paper is the first to present an equilibrium market model for two types of debt contracts with covenant. For the first type, we consider a firm issuing a bond with covenant in the primary market, whereas in the second the firm borrows a syndicated bank loan with covenant. In both models we (1) find that there is a minimum coordination level which guarantees the covenant efficiency, and we (2) identify the optimal covenant threshold.