The role of bond covenants and short-term debt: evidence from Brazil.
| Autor | Silva, Vinicius Augusto Brunassi |
| Cargo | Report |
Introduction
Companies with growth opportunities may choose to have an increasing financing leverage. By choosing a higher leverage, many companies choose to finance projects by issuing long-term debt. Long-term financiers may require additional support from shareholders to enter into a long-term financing agreement, such as restrictions on dividend payments, additional leverage, collateral structures and so forth. The use of financial covenants have been used to mitigate possible agency costs between shareholders and debt holders which may lead to suboptimal investments (underinvestment), as suggested by Myers (1977).
In this paper we study how Brazilian companies have chosen to use financial covenants and to what extent this can be used to reduce agency problems. As suggested by Billet, King and Mauer (2007), this paper investigates whether short-term debt and covenants can be used as replacement tools addressing agency costs between owners and creditors. Moreover, several studies have demonstrated that companies with growth opportunities face difficulties in obtaining debt financing, including those by Jensen and Meckling (1976), Myers (1977), Smith and Warner (1979), and Rajan and Zingales (1995). We also investigated whether financial covenants may negatively impact implementation for growth opportunities. The relevance of this study is in identifying the role played by covenants and implications for leveraging and financing growth opportunities. Our contribution is specifically to test hypotheses related to the substitution of financial covenants and short-term debt by providing long-term financing.
The structure of this study proceeds as follows: second section discusses related literature. Third section describes our date set, variables and empirical model. Fourth section provides empirical results and considerations. Final section concludes the paper.
Restrictive Covenants and Short-Term Debt Contributions to Reducing Agency Conflict
Since the works by Jensen and Meckling (1976), Myers (1977), and Smith and Warner (1979), it has been possible to distinguish costs of value transfer and costs related to agreement mechanisms for mitigating conflicts between shareholders and creditors. Regarding the transfer of value, when managers seek to maximize shareholder value rather than maximize value for the company, there is the possibility of overinvestment or underinvestment in future growth opportunities. Thus, the loss of value to the company resulting from this attitude is characterized as an agency cost. Moreover, mechanisms that help reduce conflict of interests and possible reductions capital cost (debt covenants and short-term debt) also have costs related to its accession. After studies by Jensen and Meckling (1976) and Myers (1977), Smith and Warner (1979) realized that the choice of covenants in a contract may indirectly and simultaneously affect an enterprise's other activities, such as investment decisions, payout policy and leverage.
As mentioned by Billet et al. (2007), although it is possible to reduce such agency conflicts without changing the existing level of debt through the use of short-term debt and restrictive covenants, there are some precautions related to a growth opportunity scenario that a company should take. In a growth opportunity scenario, the use of covenants in debt agreements may limit the opportunities perceived in the future and the use of short-term debt can bring the company liquidity risk problems. As these instruments may limit future investments by firms, the logical solution is to decrease the current level of indebtedness or to use less debt to raise funds in need of funding. Therefore, the expected prediction is that firms with greater growth opportunities are less leveraged. As debt covenants and short-term debt may limit future opportunities, some companies might prefer not to raise debt instruments when they face growth opportunities. That is the reason for predicting that growth opportunities and leverage have a negative relation. In this situation, both covenants and short-term debt could be analyzed as possible tools to reduce the negative relationship between growth opportunities and long-term debt.
Studies have shown that reducing debt maturity (i. e. issuing short-term debt) can help treatment of the agency problem. Myers (1977) found that if the debt matures before the exercise growth option, maximizing value to the business can be conducted. Then, it is possible to reduce the incentive for achievement of underinvestment. According to Barclay and Smith (1995), in the event named contracting-cost, investors tend to refuse investment when there is possibility of transferring wealth to creditors. One way to alleviate the problem presented in the contracting-cost hypothesis would be reducing the maturity of debt owned and using short-term debt in subsequent issues.
Billet et al. (2007) followed the results from Johnson (2003) and Childs, Mauer and Ott (2005),
and tested the benefit of short-term debt as possibly reducing the negative relationship between leverage and growth opportunities. The result was favorable to the hypothesis of a positive relationship between the tested variables. In other words, short-term debt helps to reduce the negative relationship between leverage and growth opportunities.
As well as short-term debt, bond covenants play an import role in mitigating agency costs and also help reduce the negative relationship between leverage and growth opportunities. Bazzana and Broccardo (2009) argue that a lender will examine the trade-off between problems and costs associated with the use of covenants and benefits arising from their use and decide to include them in debt issuance, since the benefits are higher. Demerjian (2007) studied the choice of financial ratio covenants in debt agreements and found that borrowers with positive earnings, high profitability and low volatility earnings are likely to include covenants in debt agreements related to earnings, such as coverage of the debt to cash flow. On the other hand, borrowers with losses, low profitability and high volatility earnings are likely to use covenants relating to shareholder equity. Besides, Demerjian (2007) also showed that covenants related to leverage are attributed to deals with revolving lines of credit and current ratio covenants are directed to borrowers with high levels of working capital.
Therefore, the use of restrictive covenants can help reduce the negative relationship between leverage and growth opportunities, according to Billet et al. (2007). To verify this premise, they constructed indexes of covenant protection to check both the relationship between growth opportunities and covenants as the relationship between covenants, short-term debt and leverage. Companies with high growth opportunities faced higher agency conflicts. It is possible to infer that benefits resulting from the use of covenants are higher for this type of company. However, companies with these characteristics are also interested in preserving financial flexibility and future financing requirements, which do not allow the inclusion of certain restrictive clauses. Following the authors' argument, this article also predicts a positive relationship between leverage covenant and protection, as the risk of issuing new debt is higher in the presence of increased leverage.
According to the studies mentioned above, we would like to check whether debt covenants and short-term debt play a similar role in addressing agency conflict in Brazil. However, the Brazilian Corporate Bond Market has its peculiarities. Basically, Brazilian companies can raise funds in the local market by issuing Corporate Bonds, commercial papers, private bank loans, stocks and using the support of Banco Nacional de Desenvolvimento Economico e Social (BNDES), the Brazilian Development Bank.
Anderson (1999) analyzed 50 Brazilian indenture agreements and found specific characteristics for corporate bonds as a possibility to mitigate inflation risk for investors, contingent-maturity mechanisms with periodic opportunities for exit or renegotiation, a paucity of covenants that restrict a debtor's investment, financing and dividend decisions, and self-enforcement mechanisms with the purpose of avoiding reliance on inefficient institutions.
Issuers have flexibility in structuring Corporate Bonds. For example, they may promise a payment according to fixed interest or floating interest (by using some kind of indexation). They can be convertible or nonconvertible into stocks and also include collateral specifications. Filgueira and Leal (2001) stated that covenants have suffered changes in Brazilian corporate bonds since 1994. The main explanation for this supports attempts at inflation control, started in 1994 by the Brazilian government. Sanvicente (2002) presented a study which showed that corporate bonds are an important resource of funding not only for public companies, but also for companies that do not have stocks traded on the Brazilian stock market.
Saito, Sheng and Bandeira (2007) studied how covenants have been used to mitigate agency costs between stockholders and bondholders. They corroborate the work done by Filgueira and Leal (2001) mentioned above, found empirical evidence of looser covenants and showed the purpose of corporate bonds issuance; i.e. the destinations of funding raised and reasons for its issuance, such as increased working capital, operation investments and debt terms.
Finally, Silva (2008) applied the hypothesis of optical contractual covenants in the choice of accounting practices. Results demonstrated that the use of covenants has grown in recent years, especially coverage of debt covenants and debt level.
Data, Variable Measures and Model
We analyzed two databases in order to create our sample. Firstly, it was necessary to collect all available corporate bonds indentures from debentures.com.br...
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