On financial contracting: An analysis of bond covenants

With risky debt outstanding, stockholder actions aimed at maximizing the value of their equity claim can result in a reduction in the value of both the firm and its outstanding bonds. We examine ways in which debt contracts are written to control the conflict between bondholders and stockholders. We find that extensive direct restrictions on production/investment policy would be expensive to employ and are not observed. However, dividend and financing policy restrictions are written to give stockholders incentives to follow a firm-value-maximizing production/investment policy. Taking into account how contracts control the bondholder- stockholder conflict leads to a number of testable propositions about the specific form of the debt contract that a firm will choose.