How Effectively Can Debt Covenants Alleviate Financial Agency Problems?

We examine the effectiveness of debt covenants in alleviating financial agency problems. Distortions in both investment and financing policies with long--term debt are captured in a structural dynamic model where both policies are endogenously determined by shareholders. The combined and compounding effect of these distortions is shown to be large. We impose covenants that restrict the level of debt, or control the use of proceeds from asset sales or debt issuance, and analyze how, and how much, they mitigate financial agency costs. We investigate the direct and indirect impact of covenants on financing and investment policies, including at the point where covenants are violated, providing alternative interpretations of recent empirical evidence. We conclude that the presence and enforcement of debt covenants significantly alters dynamic financing and investment policies, not only at the point of covenant violations, and thus should be an important element of structural models