The Double Role of Financial Covenants in Bond Issues in Brazil.
| Autor | Konraht, Jonatan Marlon |
1 Introduction
Corporate debt contracts generally include covenants that must be complied with over the term of the debt. Since these clauses impose a variety of different constraints, they have been classified into three general covenant categories: (a) affirmative; (b) negative; and (c) financial (Nini, Smith, & Sufi, 2012). The first category comprises covenants that oblige the borrowing firm to perform certain actions, such as sending copies of its financial statements to creditors on a regular basis (Nini et al., 2012). Negative covenants impose constraints on the firm's actions, such as restricting its freedom to change shareholder control or to pay dividends (Nini et al., 2012). Finally, financial covenants are based on accounting numbers and stipulate financial conditions that the firm must meet during the debt term, such as a maximum level of debt or a minimum level of profitability (Mather & Peirson, 2006).
Covenants perform two functions in the debt contracting process: (a) they can reduce agency conflicts between the firm and its creditors (Smith & Warner, 1979), which can be achieved by all three categories of covenants; and (b) they can reduce uncertainty with relation to the issuing firm's ability to pay the debt in the future (Demerjian, 2017), which can be achieved using financial covenants. Taken in conjunction, these functions mean that employing covenants can reduce creditors' risk in relation to problems that could arise after the debt is contracted, such as agency conflicts (Smith & Warner, 1979), or insolvency (Demerjian, 2017). Consequently, the inclusion of these clauses would tend to increase the firm's ability to obtain finance from creditors, and improve the contractual conditions of the debt.
Based on this reasoning, empirical studies have been undertaken to identify the effect of covenants on the cost of issuing debt. However, while these studies have made contributions to the financial and accounting literature, certain questions about the role of covenants in relation to the cost of debt remain unanswered.
The first of these issues is related to the disparate results reported for the relationship between covenants and the cost of debt. For example, studies undertaken in the United States (Reisel, 2014; Bradley & Roberts, 2015; Simpson & Grossmann, 2017) and in China (Gong, Xu, & Gong, 2015), investigating private corporate loan markets and public bond markets, have found that the inclusion of covenants that limit managers' freedom with relation to investment and borrowing policies tend to reduce the cost of debt. However, another body of evidence indicates that covenants may also be related to higher debt spreads (Graham, Li, & Qiu, 2008; Hasan, Park, & Wu, 2012; Knyazeva & Knyazeva, 2012). These studies were conducted using data from the private debt (bank loans) market in the United States and suggest that creditors use risk premiums and the inclusion of covenants as complementary mechanisms to protect the capital provided. Thus, firms that pay higher yields to acquire resources also have to comply with larger numbers of covenants.
A second unanswered question is whether the role of covenants varies as a function of their different categories, especially in terms of the distinction between financial and non-financial covenants. One issue that feeds this debate is that the two classes of financial and non-financial covenants have specific characteristics and play different roles in the contractual relationship between a firm and its creditors. While non-financial covenants define obligations (affirmative covenants) or impose prohibitions (negative covenants), financial covenants define financial parameters that must be met by borrowers. It is therefore possible that creditors may view financial and non-financial covenants differently at the time of assessing the risk of securities and that they have different implications for the pricing process. Evidence to support these hypotheses has been reported by Chang and Ross (2016), who conducted tests with market analysts and found that they consider covenants that offer protection against the debt issuer's risk of bankruptcy to be of greatest relevance. Thus, financial covenants may be of greater interest to creditors, because they offer control over indicators such as debt coverage, total debt, and cash flow, among other indicators of the risk of insolvency or bankruptcy.
Additionally, another peculiarity of covenants is the possibility of writing clauses that impose obligations that must be met by companies other than the debt issuer, such as subsidiaries, parent companies, or firms that provide surety and guarantees that the issuer's debt will be repaid to the holder (Konraht, 2017). Creditors use these contractual devices to monitor both the issuing firm's risk and that of other firms that have secondary liability as guarantors, in the event that the issuer defaults on its debts. This type of formulation of the obligation to fulfill covenants has been documented in the North American (Reisel, 2014) and Brazilian (Konraht, 2017) bond markets, but there is limited evidence available on its relevance to the protection of creditors against debt agency problems. Reisel (2014) has pointed out that it is unclear whether covenants that must be fulfilled by other firms in a business group, such as subsidiaries, are of benefit to creditors in terms of reducing debt agency conflicts. It is thus a worthwhile exercise to conduct tests to ascertain whether clauses that must be fulfilled by entities providing guarantees for the issuer are of sufficient relevance to debt holders that they are priced into the spread.
Finally, it has been documented that differences in the institutional environments in which debt is contracted, such as legal enforcement and protection of creditors, change the ways in which covenants are used in debt contracts (Hong, Hung, & Zhang, 2016). With respect to this matter, Taylor (2013) has stated that there is a need for literature that seeks evidence on how covenants are used in emerging countries, such as Brazil, China, and India, since these countries have different patterns and trends of corporate finance, corporate governance, and accounting practices, compared to the developed countries where the foundations of the literature on covenants were laid.
It is against this background that this paper attempts to identify the relationship between the use of financial covenants and the cost of issuing debt via corporate bonds in Brazil. The analysis contributes to filling gaps in the literature by investigating how financial covenants are priced by creditors in an institutional environment with weak protections for creditors and poor legal enforcement and also by testing whether pricing varies as a function of which firms are obliged to fulfill financial covenants, whether (a) the debt issuer or (b) firms providing guarantees for the issuer.
Brazil is a potentially relevant institutional environment for this empirical analysis, since it is characterized by weak creditor protections and poor legal enforcement (Hong et al., 2016), both of which are factors that increase creditors' risk. Furthermore, evidence on the use of covenants in Brazil indicates that the inclusion of financial covenants to be fulfilled by guarantors is relatively common in bond issues, since approximately 12% of covenants are specified in this manner (Konraht, 2017).
Methodologically, the cost of debt was measured in terms of securities' spread, against Brazil's benchmark interbank deposit rate (DI). Financial covenants were sampled manually from bond indentures and prospectuses. The analysis encompassed tests with all financial covenants and analyses stratified by whether covenants should be fulfilled by the debt issuer or by guarantors.
The results revealed that financial covenants play a dual role in debt contracting, since the relationship between their inclusion and the cost of debt varies as a function of which firm is responsible for fulfilling them. For covenants that must be fulfilled by the debt issuer, the function of financial covenants is as a protection mechanism that complements the risk premium charged by the creditors. Thus, the higher the issuance cost, the greater the number of financial covenants that must be fulfilled exclusively by the debt issuer. In contrast, covenants that must be fulfilled by guarantors function as mechanisms to substitute the risk premium charged by the creditors. Thus, the cost of issuing debt reduces as the number of financial covenants to be fulfilled by parent companies, subsidiaries, or third-parties providing guarantees increases.
This paper therefore makes three original contributions to the literature. The first is the finding that financial covenants that must be fulfilled by guarantors reduce the cost of issuing debt. As such, the results indicate that this form of covenant is relevant to reducing the agency costs of debt, since these clauses act as a mechanism that enables creditors to monitor the capacity of the guarantors to pay, if the debt issuer defaults, thus providing answers to the questions raised by Reisel (2014) about the relevance to creditors of this type of covenant. The second contribution is the finding that in the Brazilian setting financial covenants that must be fulfilled by the debt issuer function to complement the risk premium priced into the spread of the debt issue, so that riskier issuers have to pay a higher price to borrow and accept a greater number of financial covenants that must be fulfilled by the debt issuer itself. Finally, the third contribution is to show that in the Brazilian setting financial covenants that must be fulfilled by the debt issuer and those that must be fulfilled by guarantor firms have opposite relationships with the cost of issuing debt.
It is notable that the Brazilian literature on the determinants of bond yields (Sheng &...
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