The Effect of Liquidity and Solvency Risk on the Inclusion of Bond Covenants

Gryglewicz (2011) develops a model that evaluates the effect of the two sources of financial distress, illiquidity and insolvency, on firm financial decisions. Using a comprehensive database of corporate bonds from 1985 to 2009, we analyze the impact of these two sources of financial distress on the use of bond covenants. We find that liquidity risk, measured by cash flow uncertainty has a significant and positive impact on the inclusion of all categories of bond covenants but is negatively related to the firm's ability to defense its balance sheet debt. We also determine that these results have large economic significance. For example, a 1 percent increase in stock return volatility results in respective 21.5 percent, 55.9 percent, and 79.4 increases in the probability of using investment, payment, and event covenants. Comparatively, the effect of solvency risk, measured by future profitability uncertainty, although also significant is tempered relative to the relationships between liquidity concerns and bond covenants. These comparisons underlie the importance of distinguishing between the impact of liquidity risk and that of solvency risk on bond covenant decisions. In the financial crisis period of 2008 bond covenants are reduced relative to the outside period due to a change in the mix of borrowers, which favored high quality bond issuers, but there is no discernible effect on the relationship between liquidity or solvency risk and the use of bond covenants. Our results are robust to the consideration of managerial agency risk