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Title: Efficiency in Financial Contracting: Bond Covenants and Corporate Bankruptcy

Authors: Stephen Ferris; Narayanan Jayaraman; Vidhan Goyal

Addresses: Author address listing can be found in the "About the Authors" section at the end of the article.

Abstract: This study examines the wealth loss that occurs for both stockholders and bondholders in the period surrounding the announcement of a bankruptcy. Examining a sample of 161 bonds issued by firms that subsequently went bankrupt during 1979-1990, we find that the covenant structure contained in the indenture is an important determinant of cross-sectional variability in the magnitude of the creditors' wealth loss. Covenant sets addressing the disposition of assets and control of dilution of bondholder influence were found to be statistically significant determinants of bond returns surrounding the period of bankruptcy announcement. We also document a direct relation between creditor wealth loss and the frequency of issue downgrade by professional rating agencies. Since ratings reflect an issue's covenant structure, this suggests that financial markets respond both to the presence of specific covenants as well as the evaluation of these covenants by external monitors

Keywords: Financial contracting; bond covenants; corporate bankruptcy; wealth loss; rating agencies.

DOI: 10.1504/JBM.1994.140998

Journal of Business and Management, 1994 Vol.2 No.1, pp.102 - 126

Published online: 05 Sep 2024 *