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Investment Opportunities and the Design of Debt Securities

We investigate a puzzling empirical regularity: the near-total absence of restrictive covenants from publicly traded convertible bonds issued by U.S. companies. In a study of 192 recent debt issues, we find that an issuer's investment opportunities are negatively related to the presence of covenants and positively associated with the incidence of convertibility. The results support an interpretation that covenants impose costs by limiting managers' choices, leading firms that value managerial flexibility to prefer convertibility as a method of reducing the agency costs of debt.