The Effect of Liquidity and Solvency Risk on the Inclusion of Bond Covenants

57 Pages Posted: 16 Mar 2012

See all articles by Douglas O. Cook

Douglas O. Cook

University of Alabama - Culverhouse College of Commerce & Business Administration

Xudong Fu

University of Louisville

Tian Tang

University of Louisville

Multiple version iconThere are 2 versions of this paper

Date Written: March 15, 2012

Abstract

Gryglewicz (2011) develops a model that evaluates the effect of the two sources of financial distress, illiquidity and insolvency, on firm financial decisions. Using a comprehensive database of corporate bonds from 1985 to 2009, we analyze the impact of these two sources of financial distress on the use of bond covenants. We find that liquidity risk, measured by cash flow uncertainty has a significant and positive impact on the inclusion of all categories of bond covenants but is negatively related to the firm’s ability to defense its balance sheet debt. We also determine that these results have large economic significance. For example, a 1 percent increase in stock return volatility results in respective 21.5 percent, 55.9 percent, and 79.4 increases in the probability of using investment, payment, and event covenants. Comparatively, the effect of solvency risk, measured by future profitability uncertainty, although also significant is tempered relative to the relationships between liquidity concerns and bond covenants. These comparisons underlie the importance of distinguishing between the impact of liquidity risk and that of solvency risk on bond covenant decisions. In the financial crisis period of 2008 bond covenants are reduced relative to the outside period due to a change in the mix of borrowers, which favored high quality bond issuers, but there is no discernible effect on the relationship between liquidity or solvency risk and the use of bond covenants. Our results are robust to the consideration of managerial agency risk.

Keywords: bond covenants, liquidity risk, solvency risk, financial distress

JEL Classification: G32, G33

Suggested Citation

Cook, Douglas O. and Fu, Xudong and Tang, Tian, The Effect of Liquidity and Solvency Risk on the Inclusion of Bond Covenants (March 15, 2012). Available at SSRN: https://ssrn.com/abstract=2023611 or http://dx.doi.org/10.2139/ssrn.2023611

Douglas O. Cook (Contact Author)

University of Alabama - Culverhouse College of Commerce & Business Administration ( email )

Culverhouse College of Business
Tuscaloosa, AL 35487-0223
United States
205-348-8971 (Phone)
205-348-0590 (Fax)

Xudong Fu

University of Louisville ( email )

Louisville, KY 40292
United States

Tian Tang

University of Louisville ( email )

United States
502-852-4819 (Phone)

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