Uncertainty and Debt Contracts

• In Event: Debt Contracting

Abstract

I examine the relationship between uncertainty and financial covenants in debt contracts. In the context of debt contracting, uncertainty refers to a lack of information about the borrower prior to contracting. One way to address uncertainty contractually is to renegotiate the contract when new information is received and uncertainty resolved. I argue that financial covenants represent an ex ante commitment by the borrower and creditor to renegotiate the loan, allowing the contract to incorporate new (post-contracting) information. I find robust associations between financial covenant use and different proxies for uncertainty. I also consider the common assertion that agency conflicts related to debt drive financial covenant use. Examining and exogenous shock where uncertainty increases but agency remains unchanged, I find that uncertainty is still associated with financial covenant use. This result casts doubt on the agency explanation of financial covenant inclusion.

Author

• Peter Demerjian, Emory University