Event risk covenants, design parameters and agency issues: a comparative study of high yield versus investment grade bonds
Abstract
We analyse security design parameters of 1,115 high yield (HY) and investment grade (IG) event risk covenants (ERC) protected issues between 1986 and 2012 from the agency conflict perspective. We find positive and significant stock price reaction to the issuance of HY but not the IG issues. Although, majority of these issues carry a call provision, we find significant design differences in the call provision between HY and IG issues. We find that HY issues provide strong call protection to mitigate the risk of a call due to ratings upgrade, compromising firm’s financial flexibility; resulting financial distress is mitigated by the ERC. IG issues provide weak call protection to fully exploit growth options however, role of ERC is not apparent. We also find evidence of increase in managerial entrenchment due to the presence of ERC in HY firms however, reduction in agency cost of debt supersedes cost of managerial entrenchment.
Keyword : corporate finance, financing, event risk covenants, callable debt, structured provisions, agency conflict
How to Cite
Tewari, M. (2018). Event risk covenants, design parameters and agency issues: a comparative study of high yield versus investment grade bonds. Business: Theory and Practice, 19, 331-341. https://doi.org/10.3846/btp.2018.33
This work is licensed under a Creative Commons Attribution 4.0 International License.
References
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Billet M, Dolly King T, Mauer D (2007) Growth opportunities and the choice of leverage, debt maturity, and covenants. Journal of Finance 62: 697-730. https://doi.org/10.1111/j.1540- 6261.2007.01221.x
Billet M, Hribar P, Liu Y (2015) Shareholder-Manager alignment and the cost of debt. Working Paper. https://doi.org/10.2139/ ssrn.958991
Bodie Z, Taggart R (1978) Future investment opportunities and the value of the call provision on a bond. Journal of Finance 33: 1187-1220. https://doi.org/10.1111/j.1540-6261.1978.tb02056.x
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Cook D, Easterwood J, Martin J (1992) Bondholder wealth effects of management buyouts. Financial Management 21: 102-113. https://doi.org/10.2307/3665684
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Cremers M, Nair V, Wie C (2007) Governance mechanisms and bond prices. Review of Financial Studies 20: 1359-1388. https://doi.org/10.1093/revfin/hhm006
Diamond D (1991) Debt maturity structure and liquidity risk. Quarterly Journal of Economics 106: 709-737. https://doi.org/10.2307/2937924
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Fields J, Kidwell A, Klein L (1994) Coupon resets versus poison puts: the valuation of event risk provisions in corporate debt. Financial Services Review 3: 143-156. https://doi.org/10.1016/1057-0810(94)90019-1
Ghouma H (2017) How does managerial opportunism affect the cost of debt financing? Research in International Business and Finance 39: 13-29. https://doi.org/10.1016/j.ribaf.2016.07.007
Gilson S, Warner J (1998) Private versus public debt: evidence from firms that replace bank loans with junk bonds. Working paper, Harvard Business School.
Guedes J, Opler T (1996) The determinants of the maturity of corporate debt issues. Journal of Finance 51: 1809-1833. https://doi.org/10.1111/j.1540-6261.1996.tb05227.x
Harris M, Raviv A (1990) Capital structure and the information role of debt. Journal of Finance 45: 321-349. https://doi. org/10.1111/j.1540-6261.1990.tb03693.x
Harvey C, Lins K, Roper A (2004) The effect of capital structu- re when expected agency costs are extreme. Journal of Financial Economics 74: 3-30. https://doi.org/10.1016/j.jfineco.2003.07.003
Hege U, Hennessey C (2010) Acquisition values and optimal financial (in)flexibility. Review of Financial Studies 23: 2866-2899. https://doi.org/10.1093/rfs/hhq017
Helwege J, Huang J, Wang Y (2016) Debt covenants and cross- sectional equity returns. Management Science 63: 1657-2048. https://doi.org/10.1287/mnsc.2015.2381
Jensen M (1986) Agency costs of free cash flow, corporate finan- ce and takeovers. American Economic Review 76: 323-339. https://www.jstor.org/stable/1818789
Jensen M, Meckling W (1976) Theory of the firm: managerial behavior, agency costs, and ownership structure. Journal of Financial Economics 3: 305-360. https://doi.org/10.1016/0304-405X(76)90026-X
Kahan M, Klausner M (1993) Antitakeover provisions in bonds: bondholder protection or management entrenchment? UCLA Law Review (April): 931-982.
Kahan M, Yermack D (1998) Investment opportunities and the design of debt securities. Journal of Law, Economics and Organization 14: 136-151. https://doi.org/10.1093/oxford-journals.jleo.a023394
Kish R, Livingston M (1992) Determinants of the call option on corporate bonds. Journal of Banking & Finance 16: 687-703. https://doi.org/10.1016/0378-4266(92)90002-H
Korkeamaki T, Moore W (2004) Convertible bond design and capital investment: the role of call provisions. Journal of Finance 59: 391-405. https://doi.org/10.1111/j.1540- 6261.2004.00636.x
Lehn K, Poulsen J (1989) Free cash flow and stockholder gains in going private transactions. Journal of Finance 77: 1-788. https://doi.org/10.1111/j.1540-6261.1989.tb04390.x
Leland H (1994) Corporate debt value, bond covenants, and optimal capital structure. Journal of Finance 49: 1213-1252. https://doi.org/10.1111/j.1540-6261.1994.tb02452.x
McDaniel M (1986) Bondholders and corporate governance. The Business Lawyer 41: 413-460.
Mikkelson W, Partch M (1986) Valuation effects of security offe- rings and the issuance process. Journal of Financial Econo- mics 15: 31-60. https://doi.org/10.1016/0304-405X(86)90049-8
Miller D (1999) The market reaction to international cross-listing: evidence from depositary receipts. Journal of Financial Economics 51: 103-123. https://doi.org/10.1016/S0304-405X(98)00045-2
Nanda V, Yun Y (1996) Financial innovation and investor wealth: a study of the poison put in convertible bonds. Journal of Corporate Finance 3: 1-22. https://doi.org/10.1016/S0929-1199(96)00005-3
Nash R, Netter J, Poulsen A (2003) Determinants of contractual relations between, shareholders and bondholders: investment opportunities and restrictive covenants. Journal of Corporate Finance 9: 201-232. https://doi.org/10.1016/S0929-1199(02)00007-X
Perumpral S, Davidson D, Sen N (1999) Event risk covenants and shareholder wealth: ethical implications of the “poison put” provision in bonds. Journal of Business Ethics 22: 119-132. https://doi.org/10.1023/A:1006091829986
Robbins E, Schatzberg J (1986) Callable bonds: a risk-reducing signalling mechanism. Journal of Finance 41: 935-949. https:// doi.org/10.1111/j.1540-6261.1986.tb04558.x
Roth G, McDonald C (1999) Shareholder-management conflict and event risk covenants. Journal of Financial Research 22: 207-225. "https://doi.org/10.1111/j.1475-6803.1999.tb00723.x
Scholes M, Williams J (1977) Estimating betas from nonsynchro- nous data. Journal of Financial Economics 5: 309-327. https:// doi.org/10.1016/0304-405X(77)90041-1
Shleifer A, Vishny R (1989) Management entrenchment: the case of manager-specific investments. Journal of Financial Economics 25: 123-140. https://doi.org/10.1016/0304-405X(89)90099-8
Smith C, Smithson C, Wilford D (1989) Managing financial risk. Journal of Applied Corporate Finance 2: 27-48. https://doi.org/10.1111/j.1745-6622.1989.tb00172.x
Stulz R (1990) Managerial discretion and optimal financing policies. Journal of Financial Economics 26: 3-27. https://doi.org/10.1016/0304-405X(90)90011-N
Tewari M, Ramanlal P, Byrd A (2015) Callable bonds, reinves- tment risk, and credit rating improvements: role of the call premium. Journal of Financial Economics 115: 349-360. https://doi.org/10.1016/j.jfineco.2014.09.011
Thatcher J (1985) The choice of call provision terms: evidence of the existence of agency costs of debt. Journal of Finance 40: 549-561. https://doi.org/10.1111/j.1540-6261.1985.tb04972.x
Warga A, Welch I (1993) Bondholder losses in leveraged buyouts. Review of Financial Studies 6: 959-982. https://doi. org/10.1093/rfs/6.4.959
Winn W, Hess A (1959) The value of the call privilege. Journal of Finance 14: 182-195. https://doi.org/10.1111/j.1540-6261.1959. tb01580.x
Xu Q (2017) Kicking maturity down the road: early refinancing and maturity management in the corporate bond market. Review of Financial Studies 31: 3061-3097. https://doi. org/10.1093/rfs/hhx116
Zhang X, Zhou S (2018) Bond covenants and institutional block- holdings. Journal of Banking and Finance 96: 136-152. https://doi.org/10.1016/j.jbankfin.2018.09.006
Asquith P, Wizman T (1990) Event risk, covenants, and bond- holder returns in leveraged buyouts. Journal of Financial Economics 27: 195-213. https://doi.org/10.1016/0304-405X(90)90026-V
Avramov D, Chordia T, Jostova G, Philipov A (2007) Momentum and credit rating. Journal of Finance 62: 2503-2520. https://doi.org/10.1111/j.1540-6261.2007.01282.x
Bae S, Klein D, Padmaraj R (1994) Event risk bond coven- ants, agency costs of debt and equity, and stockholder wealth. Financial Management 23: 28-41. https://doi. org/10.2307/3666081"
Barnea A, Haugen R, Senbet L (1980) A rationale for debt ma- turity structure and call provisions in the agency theoretic framework. Journal of Finance 35: 1223-1234. https://doi. org/10.1111/j.1540-6261.1980.tb02205.x
Begley J (1994) Restrictive covenants included in public debt agreements: an empirical investigation. Unpublished working paper. University of British Columbia, Vancouver.
Bhanot K, Mansi S, Wald J (2010) Takeover risk and the corre- lation between stocks and bonds. Journal of Empirical Finance 17: 381-393. https://doi.org/10.1016/j.jempfin.2009.10.006
Billet M, Dolly King T, Mauer D (2007) Growth opportunities and the choice of leverage, debt maturity, and covenants. Journal of Finance 62: 697-730. https://doi.org/10.1111/j.1540- 6261.2007.01221.x
Billet M, Hribar P, Liu Y (2015) Shareholder-Manager alignment and the cost of debt. Working Paper. https://doi.org/10.2139/ ssrn.958991
Bodie Z, Taggart R (1978) Future investment opportunities and the value of the call provision on a bond. Journal of Finance 33: 1187-1220. https://doi.org/10.1111/j.1540-6261.1978.tb02056.x
Cook D, Easterwood J (1994) Poison put bonds: an analysis of their economic role. Journal of Finance 49: 1905-1920. https://doi.org/10.1111/j.1540-6261.1994.tb04787.x
Cook D, Easterwood J, Martin J (1992) Bondholder wealth effects of management buyouts. Financial Management 21: 102-113. https://doi.org/10.2307/3665684
Crabbe L (1991) Event risk: an analysis of losses to bondholders and “super poison put” bond covenants. Journal of Finance 46: 689-706. https://doi.org/10.1111/j.1540-6261.1991.tb02680.x
Cremers M, Nair V, Wie C (2007) Governance mechanisms and bond prices. Review of Financial Studies 20: 1359-1388. https://doi.org/10.1093/revfin/hhm006
Diamond D (1991) Debt maturity structure and liquidity risk. Quarterly Journal of Economics 106: 709-737. https://doi.org/10.2307/2937924
Ederington L, Stock D (2002) Impact of call features on corporate bond yields. Journal of Fixed Income 12: 58-68. https://doi. org/10.3905/jfi.2002.319325
Fields J, Kidwell A, Klein L (1994) Coupon resets versus poison puts: the valuation of event risk provisions in corporate debt. Financial Services Review 3: 143-156. https://doi.org/10.1016/1057-0810(94)90019-1
Ghouma H (2017) How does managerial opportunism affect the cost of debt financing? Research in International Business and Finance 39: 13-29. https://doi.org/10.1016/j.ribaf.2016.07.007
Gilson S, Warner J (1998) Private versus public debt: evidence from firms that replace bank loans with junk bonds. Working paper, Harvard Business School.
Guedes J, Opler T (1996) The determinants of the maturity of corporate debt issues. Journal of Finance 51: 1809-1833. https://doi.org/10.1111/j.1540-6261.1996.tb05227.x
Harris M, Raviv A (1990) Capital structure and the information role of debt. Journal of Finance 45: 321-349. https://doi. org/10.1111/j.1540-6261.1990.tb03693.x
Harvey C, Lins K, Roper A (2004) The effect of capital structu- re when expected agency costs are extreme. Journal of Financial Economics 74: 3-30. https://doi.org/10.1016/j.jfineco.2003.07.003
Hege U, Hennessey C (2010) Acquisition values and optimal financial (in)flexibility. Review of Financial Studies 23: 2866-2899. https://doi.org/10.1093/rfs/hhq017
Helwege J, Huang J, Wang Y (2016) Debt covenants and cross- sectional equity returns. Management Science 63: 1657-2048. https://doi.org/10.1287/mnsc.2015.2381
Jensen M (1986) Agency costs of free cash flow, corporate finan- ce and takeovers. American Economic Review 76: 323-339. https://www.jstor.org/stable/1818789
Jensen M, Meckling W (1976) Theory of the firm: managerial behavior, agency costs, and ownership structure. Journal of Financial Economics 3: 305-360. https://doi.org/10.1016/0304-405X(76)90026-X
Kahan M, Klausner M (1993) Antitakeover provisions in bonds: bondholder protection or management entrenchment? UCLA Law Review (April): 931-982.
Kahan M, Yermack D (1998) Investment opportunities and the design of debt securities. Journal of Law, Economics and Organization 14: 136-151. https://doi.org/10.1093/oxford-journals.jleo.a023394
Kish R, Livingston M (1992) Determinants of the call option on corporate bonds. Journal of Banking & Finance 16: 687-703. https://doi.org/10.1016/0378-4266(92)90002-H
Korkeamaki T, Moore W (2004) Convertible bond design and capital investment: the role of call provisions. Journal of Finance 59: 391-405. https://doi.org/10.1111/j.1540- 6261.2004.00636.x
Lehn K, Poulsen J (1989) Free cash flow and stockholder gains in going private transactions. Journal of Finance 77: 1-788. https://doi.org/10.1111/j.1540-6261.1989.tb04390.x
Leland H (1994) Corporate debt value, bond covenants, and optimal capital structure. Journal of Finance 49: 1213-1252. https://doi.org/10.1111/j.1540-6261.1994.tb02452.x
McDaniel M (1986) Bondholders and corporate governance. The Business Lawyer 41: 413-460.
Mikkelson W, Partch M (1986) Valuation effects of security offe- rings and the issuance process. Journal of Financial Econo- mics 15: 31-60. https://doi.org/10.1016/0304-405X(86)90049-8
Miller D (1999) The market reaction to international cross-listing: evidence from depositary receipts. Journal of Financial Economics 51: 103-123. https://doi.org/10.1016/S0304-405X(98)00045-2
Nanda V, Yun Y (1996) Financial innovation and investor wealth: a study of the poison put in convertible bonds. Journal of Corporate Finance 3: 1-22. https://doi.org/10.1016/S0929-1199(96)00005-3
Nash R, Netter J, Poulsen A (2003) Determinants of contractual relations between, shareholders and bondholders: investment opportunities and restrictive covenants. Journal of Corporate Finance 9: 201-232. https://doi.org/10.1016/S0929-1199(02)00007-X
Perumpral S, Davidson D, Sen N (1999) Event risk covenants and shareholder wealth: ethical implications of the “poison put” provision in bonds. Journal of Business Ethics 22: 119-132. https://doi.org/10.1023/A:1006091829986
Robbins E, Schatzberg J (1986) Callable bonds: a risk-reducing signalling mechanism. Journal of Finance 41: 935-949. https:// doi.org/10.1111/j.1540-6261.1986.tb04558.x
Roth G, McDonald C (1999) Shareholder-management conflict and event risk covenants. Journal of Financial Research 22: 207-225. "https://doi.org/10.1111/j.1475-6803.1999.tb00723.x
Scholes M, Williams J (1977) Estimating betas from nonsynchro- nous data. Journal of Financial Economics 5: 309-327. https:// doi.org/10.1016/0304-405X(77)90041-1
Shleifer A, Vishny R (1989) Management entrenchment: the case of manager-specific investments. Journal of Financial Economics 25: 123-140. https://doi.org/10.1016/0304-405X(89)90099-8
Smith C, Smithson C, Wilford D (1989) Managing financial risk. Journal of Applied Corporate Finance 2: 27-48. https://doi.org/10.1111/j.1745-6622.1989.tb00172.x
Stulz R (1990) Managerial discretion and optimal financing policies. Journal of Financial Economics 26: 3-27. https://doi.org/10.1016/0304-405X(90)90011-N
Tewari M, Ramanlal P, Byrd A (2015) Callable bonds, reinves- tment risk, and credit rating improvements: role of the call premium. Journal of Financial Economics 115: 349-360. https://doi.org/10.1016/j.jfineco.2014.09.011
Thatcher J (1985) The choice of call provision terms: evidence of the existence of agency costs of debt. Journal of Finance 40: 549-561. https://doi.org/10.1111/j.1540-6261.1985.tb04972.x
Warga A, Welch I (1993) Bondholder losses in leveraged buyouts. Review of Financial Studies 6: 959-982. https://doi. org/10.1093/rfs/6.4.959
Winn W, Hess A (1959) The value of the call privilege. Journal of Finance 14: 182-195. https://doi.org/10.1111/j.1540-6261.1959. tb01580.x
Xu Q (2017) Kicking maturity down the road: early refinancing and maturity management in the corporate bond market. Review of Financial Studies 31: 3061-3097. https://doi. org/10.1093/rfs/hhx116
Zhang X, Zhou S (2018) Bond covenants and institutional block- holdings. Journal of Banking and Finance 96: 136-152. https://doi.org/10.1016/j.jbankfin.2018.09.006