THE ROLE OF ACCOUNTING-BASED FINANCIAL COVENANTS IN PREVENTING SUBSTANTIVE DEFAULTS OF PUBLIC DEBT
Open Access
- Author:
- Bozanic, Zahn
- Graduate Program:
- Business Administration
- Degree:
- Doctor of Philosophy
- Document Type:
- Dissertation
- Date of Defense:
- April 27, 2011
- Committee Members:
- Karl A Muller Iii, Dissertation Advisor/Co-Advisor
Dan Givoly, Committee Member
Paul David Fischer, Committee Chair/Co-Chair
Karl A Muller Iii, Committee Chair/Co-Chair
Orie Edwin Barron, Committee Member
Marie Therese Reilly, Committee Member - Keywords:
- consent solicitations
bonds
covenants
Public debt
contracts
monitoring
renegotiation
default
credit ratings
financial reporting quality - Abstract:
- This paper hypothesizes that the presence of accounting-based financial (ABF) covenants in public debt will have an impact on a lender's ability to monitor and the borrower's response to enhanced monitoring, leading to a reduced likelihood of substantive defaults. Because of the relative ease of their monitoring, ABF covenants may serve to increase the frequency of technical defaults. It is hypothesized, however, that this same characteristic of ABF covenants would reduce the likelihood of substantive default since the presence of ABF covenants provides an incentive mechanism for managers of firms to take actions ahead of technical default to prevent acceleration and bankruptcy. The evidence presented is consistent with this hypothesis: the presence of ABF covenants increases the probability of renegotiation and thus reduces the probabilities of substantive default and credit rating downgrade in below investment grade debt. Further, this reduction is positively associated with the extent of the quality of the firm's information environment and financial reporting. Additional evidence provided shows that the presence of ABF covenants reduces initial offering yields. The findings of the paper have implications for public debt contract design and are therefore relevant to contracting parties in terms of i) enhancing the ability of lenders to assess risks and recover investment and ii) lowering the cost of debt and reducing the likelihood of bankruptcy for borrowers.