Roy’s (1952) Revisited in Today’s Investing Contexts

Manuel Tarrazo

Accounting and Finance Research, 2022, vol. 11, issue 3, 14

Abstract: Prior research has documented effects of bank loan covenant violations on various firm behaviors from the perspective of shareholders. Our paper extends this stream of research by examining how bank loan covenant violations affect public corporate bondholders. Using an event study approach, we find that the bond price response to a bank loan covenant violation is marginally negative in the 1990s and becomes significantly positive in the 2000s. The favorable price response in more recent years indicates that bondholders benefit from covenant violations. The differential bond price responses suggest an evolution of banks' use of loan covenants. Specifically, banks gradually take covenants as "trip wires," enabling them to step in and take necessary actions to safeguard their interests when early warning signals show up through covenant violations. Such disciplinary actions benefit not only banks but also bondholders. In addition, this paper finds that bondholder and stockholder reactions are positively correlated in the 2000s and that managerial entrenchment could decrease banks' influence after covenant violations.

Date: 2022
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Persistent link: https://EconPapers.repec.org/RePEc:jfr:afr111:v:11:y:2022:i:3:p:14

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