Bondholder Reactions to Bank Loan Covenant Violations and the Evolution of Bank Loan Covenants

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1 Bondholder Reactions to Bank Loan Covenant Violations and the Evolution of Bank Loan Covenants Che-Wei Chiu Winona State University Department of Accounting School of Business Winona, MN Yuqian Wang Winona State University Department of Finance School of Business Winona, MN Shu-Ling Wu National Taiwan University Department of Accounting Taipei, Taiwan

2 Bondholder Reactions to Bank Loan Covenant Violations and the Evolution of Bank Loan Covenants Abstract This paper examines firms bond price reactions to bank loan covenant violations. Using an event study approach, we find that firms bond price response is marginally negative in the 1990s and becomes significantly positive in the 2000s. The positive bond price reactions suggest bond holders benefit from bank loan covenant violations in recent years. Specifically, bank loan covenant violations enable banks to step in and take necessary actions to protect creditors interests, which benefit not only private lenders but also public debt holders, i.e., bond holders. In addition, the temporal change in bond price response suggests the disciplining role of bank loan covenants becomes increasingly important in recent years: banks gradually take debt covenants as trip wires, which give banks an option to take necessary actions when the early warning signal shows up through covenant violations. We further find that bondholders and stockholder reactions are positively correlated in recent years, and that managerial entrenchment could decrease banks influence after violations. Keywords: Debt covenant violation, bond price reactions, stock price reactions JEL: G21, G30, G31 2

3 1. Introduction Debt covenants play a substantial role in mitigating agency conflicts between creditors and shareholders. They protect creditors from wealth expropriation due to asset substitution and over/under-investment (Jensen and Meckling (1976), Myers (1977), and Smith and Warner (1979)). However, the bank loan covenants are often violated. Roberts and Sufi (2009) show that more than one quarter of publicly listed firms in the United States have bank loan covenant violations between 1996 and In response to bank loan covenant violations, banks often reduce size of credit facility, increase interest rate and/or ask for additional collateral. In contrast, public bondholders are less likely to take similar actions when covenants of public bond are violated, since public bondholders are highly dispersed and violations of public bond covenants typically lead to liquidation. What are the reactions of public bondholders to bank loan covenant violations? Are there any spillover effects of bank loan covenant violations? And how do violations affect bondholders and stockholders wealth? This paper seeks to investigate these questions. Bank loan covenant violations may negatively affect bondholders, since violations could signal deterioration of firm financial performance and precede payment defaults. Moreover, bondholders can seldom alter the main terms of debt contracts before maturity, while actions taken by banks after violations, such as increasing their interest rate or requiring additional collateral, could negatively affect firms ability to service the public debt. This hypothesis indicates negative bond reactions. And when banks increase their interest rate, require additional collateral, etc., negative reactions become more significant. 1 This prediction is supported by Esmer (2010), who documents a significant increase of firm risk in the year following covenant 1 Actions taken by banks are recorded in SEC 10-K and 10-Q filings. According to Roberts and Sufi (2009), creditors take certain type of actions in 32.2% of the violations they study. 3

4 violations. Esmer (2010) claims that creditor intervention after violations can be countered by risk-shifting behavior of managers, and that agency conflicts between creditors and shareholders are heightened as a result of bank loan covenant violations. On the other hand, technical violations of loan covenants occur relatively often and they do not necessarily indicate that borrowers are in serious financial difficulty. As claimed by Dichev and Skinner (2002), private lenders set debt covenants tightly and use them as trip wires, which provide creditors an option to step in and take action before something really bad happens. Nini, Smith, and Sufi (2012) show that bank loan violations are followed by a decline in acquisitions and capital expenditures, a sharp reduction in leverage and shareholder payouts, and an increase in CEO turnover due to formal or informal influence exerted by private creditors. They also document improvements in operating performance and stock price after violations. Specifically, both operating and stock performance of firms start to rise gradually within one or two years after violations although they fall sharply within one year before violations. Additionally, in contrast to Esmer (2010) who claims that managers shift risk after violations, Fu and Zhang (2011) find that manager risk taking incentives decrease after violations. If private lenders use covenant violations as an early warning signal to maintain close scrutiny over the performance of borrowers, reverse declining financing and operating performance, and protect themselves from real potential damage, we would expect a positive response of public debt holders to bank loan covenant violations. The two hypotheses discussed above are not mutually exclusive. Net effects of bank loan covenant violations depend on the severity of current financial performance and potential improvements of corporate governance in the near future. Admittedly, it is also possible that violations of loan covenants occur randomly, and could have no real effects on firms or creditors. 4

5 In this case, public bondholders are expected to have no significant responses to violations. Data on bank loan covenant violations between 1997 and 2008 in our paper are collected by Nini, Smith and Sufi (2012) from SEC filings, and available on Sufi s website 2. We use daily bond prices from Bloomberg Corporate BGN Price database and Lehman Brother bond index from Datastream database to calculate excess bond returns. Compared with TRACE, which started to record bond trades in June 2002, Bloomberg provides us daily bond prices back to 1990s. We find significantly positive bond price reactions in 2000s and marginally negative or even insignificant reactions in late 1990s. Specifically, the daily excess return of below investment bonds from 2003 to 2008 is 8.66 bps (basis points) while it is bps between 1997 and In order to show that our results are not data sensitive, we also use monthly bond data from Mergent/Moody s bond record ( ) and daily bond data from TRACE ( ) to do the robustness tests is the first year when TRACE started to record the flat trading price of public bonds and 2003 is the last year when Mergent/Moody s bond record updated bond prices monthly. Consistent with the findings based on Bloomberg Corporate BGN Price database, bondholders have marginally negative reactions to bank loan violations around violation filing date between 1997 and 2003 using Mergent/Moody s bond record, while bondholders have significantly positive reactions between 2002 and 2008 using TRACE database. Our results indicate that bondholders are actually beneficiaries, rather than victims of bank loan covenant violations in recent years. We also show that the time effects on investors reactions cannot be totally explained by firm characteristics. Based on LPC DealScan database between year 1990 and 2008, the average number of bank loan financial covenants on US public firms with bank loans rose sharply in 2 We would like to thank Amir Sufi for providing the access to the debt covenant violation data. 5

6 1990s, and slowed down in 2000s, which infers evolution in the application of bank loan covenants: banks gradually add more and/or tighter covenants to loans, take debt covenants as trip wires, and play an active role in corporate governance once any covenant is violated. This paper also investigates the important and unexamined association between excess stock returns and bond returns. We find that market reactions of bondholders and stockholders are positively correlated in 2000s. One dollar increase in the bondholder wealth is associated with 59 cents increase in the stockholder wealth. The positive association indicates that both bondholders and stockholders benefit from influence exerted by banks when loan covenants were violated in 2000s. In contrast, the positive association is not significant before Last, we examine the effects of managerial entrenchment on the association between bondholders and stockholders market reactions. On one side, when the firm has great managerial entrenchment, the influence exerted by banks after covenant violations could be attenuated. On the other hand, firms with severe entrenchment have bigger room for improvement and thus are more sensitive to positive influence by banks. In the subsample of bank loan covenant violations between 2000 and 2008, we find that one dollar increase of bondholder wealth is associated with one dollar increase of stockholder wealth, when the firm has good corporate governance. And the association between stock market and bond market is insignificant, when the firm has bad corporate governance. This finding indicates that great managerial entrenchment hampers banks progress to improving firms performance, rather than leaves room for the future improvement. The remainder of the paper is organized as follows. We review related literature in Section 2 and discuss our data in Section 3. In Section 4, we test our hypothesis about bond price reactions to bank loan covenant violation and the association between bondholder and stockholder market reactions. Section 5 presents the conclusions. 6

7 2. Literature review This paper extends literature on the effect of debt covenant violations. Recent studies focus on effects of bank loan covenant violations on different firm behaviors but do not directly investigate whether bondholders benefit from these changes brought by bank loan covenant violations. For example, Chava and Roberts (2008) show that capital investment declines sharply following a financial covenant violation. Roberts and Sufi (2009) find that net debt issuing activity experiences a sharp and persistent decline following debt covenant violations. Nini, Smith and Sufi (2012) provide a comprehensive analysis of the impact of bank loan covenant violations and find that violations are followed with a decrease in acquisitions, capital expenditures, leverage and shareholder payouts, and an increase in CEO turnover. Sometimes, there is mixed evidence. Esmer (2010) claims that managers shift risk after violations while Fu and Zhang (2011) find that managers risk taking incentives decrease after violations. Our paper supplements the literature by showing that on average public creditors are actually beneficiaries, rather than victims of loan covenant violations after Our finding is more consistent with the argument in Fu and Zhang (2011). This paper is also related to a large body of research on the unique monitoring function of banks and their relation with bondholders. Black (1975) and Fama (1985) claim that as insiders, banks have a low-cost ongoing history of financial information that gives them a comparative cost advantage in making and monitoring borrowing firms than public debt holders do. Diamond (1984) analyses the determinants of delegation costs and theoretically prove that a financial intermediary, such as a bank, has a net information cost advantage relative to direct lending and borrowing in public debt market. Additionally, empirical studies present much evidence that stock market positively respond to the loan commitments (James (1987), Mikkelson and Partch 7

8 (1986), Lummer and McConnell (1989)). Datta, Iskandar-Datta and Patel (1999) find that the existence of a bank relationship lowers the initial cost of public debt financing due to crossmonitoring benefits by bank debt. Our paper provides new evidence that in addition to crossmonitoring benefits, bondholders also benefit from intervention by banks after bank loan covenant violations. Additionally, positive association between bond and stock price reactions presents a synergy effect of firm improvement on bondholders and shareholders. Finally, our investigation is related to several studies on debt covenants evolution in law. Debt contracts use boilerplate language (Simpson (1973)). That is, a standard provision in the bond contract could be used over and over without too much change. Whitedhead (2009) claims that private debt may move from its traditional dependence on covenants and monitoring to a reliance on liquid credit instruments. Our paper documents a sharp increase in the average number of bank loan covenants on US public firms with loans during the late 1990s. Banks depend on more covenants, and play an active role in corporate governance after violations. This is consistent with the trip wires story in Dichev and Skinner (2002). 3. Data and Definitions of Variables A. Sample Data on bank loan covenant violations are collected by Nini, Smith and Sufi (2012) from SEC filings and available on Sufi s website. New bank loan covenant violations are defined to be violations by firms that did not violate any bank loan covenants in the previous four quarters. There are 4,178 new bank loan covenant violations of 3,145 unique nonfinancial public firms between 1997 and The SEC filing date (always on the last day of a calendar month) is considered as the official report date of bank loan covenant violations. 8

9 Daily bond prices from 1997 to 2008 are collected from Bloomberg. Compared with data in TRACE, the historical daily bond prices in the Bloomberg system go back to early 1990s. Bloomberg receives prices from many dealers via transactions which are recorded on the Bloomberg trading system. The daily bond price used in this paper is the last mid-price of a trading day. We start by requiring that the total debt of a firm is not zero in the year of violation filing date and that the firm has a bond rating. Meanwhile, we cross check whether these firms have bonds outstanding based on maturity and offering date of new bond issues from the Mergent Fixed Income Securities Database (FISD) database and get the 9 digit CUSIP of each bond outstanding. Only nonconvertible US public bonds are included in this paper. Bonds with prices below 30 are excluded to rule out zero coupon bonds. If a firm has multiple bonds, the one with longer maturity, larger amount outstanding and less security is selected as the representative bond. This process leads to 508 observations. For each observation, we hand collect the last available bond price before bank loan covenant violation filing date, P0, and the first available bond price after the violation filing date, P1, from Bloomberg using 9 digit CUSIP number. Both P0 and P1 are required to be within 30 days of the filing date. If prices of the representative bond are missing or the prices are not within 30 days of the filing date, we will try to find another representative bond with necessary information available when the firm has multiple bonds. In the end, we get 193 observations where we can compute bond price reactions to bank loan covenant violations. This paper also extracts bond prices from TRACE and Mergent/Moody s bond record for robustness tests. Daily bond prices from TRACE are from 2002 to is the first year when TRACE started to record the flat trade price of each bond transaction and 2008 is the last year when the bank loan covenant violation is recorded. If there are multiple transactions within 9

10 one trading day, the average trade price is taken for the bond. Monthly bond prices from Mergent/Moody s bond record are from 1997 to is the first year when the bank loan covenant violation is recorded and 2003 is the last year when Mergent/Moody s bond record updated bond prices monthly. Quotations for listed issues in Mergen/Moody s bond record represent the latest actual sale prices in a calendar month. If no recent transaction is made, the bid or asked price is recorded. Lehman Brother bond index monthly returns with accrued interests are collected from Datastream database, and they are used as the benchmark to compute excess bond returns. There are eight Moody s bond rating categories (Aaa, Aa, A, Baa, Ba, B, Caa, Ca-D) in each of two maturity categories (Long term and intermediate term) resulting in 16 different bond indices. All bonds are then grouped into 16 categories based on their ratings and maturity. Daily stock returns and value weighted market returns come from CRSP. Fama and French three factors (i.e. excess market returns, excess returns of small caps over big caps, and excess returns of value stocks over growth stocks) and the momentum factor come from Kenneth French s web site at Dartmouth. Additionally, firm financial information is taken from Compustat. G-index is taken from RiskMetrics to test the managerial entrenchment effects on our results. B. Main Variables Daily excess bond returns are computed as the difference between daily average bond return (change in price plus accrued interest) and daily average index return. Specifically, the excess return is equal to N M 0 [( P Accrued interest ) / P ] (1 R index ) 10

11 where P 1 is the first available bond price after the bank loan covenant violation filing date while P 0 is the last available bond price before the violation filing date, N is the number of trading days between P 1 and P 0, M is the number of trading days of the violation month, and Rindex is the Lehman Brother monthly bond index return of the violation month. Since bonds are traded less frequently than stocks, it is common that some bonds do not have any transactions on a certain trading day. Therefore, the length of event window, N, could be different for each event. As shown in Panel A, Table 1, the average length of event window is 6.13 trading days for the full sample. Monthly excess bond returns are computed as the difference between monthly bond return (change in price plus accrued interest) and monthly index return. Specifically, [( P Accrued interest ) / P ] R 1,( t 1,0, 1) t 1, m t, m t 1, index where Rt 1, index is the Lehman Brother monthly bond index return; Ptm, ( t 1,0, 1) is the monthly bond price from Mergent/Moody bond record. t stands for different event months: t equal to 0 is the month of violation filing date; t equal to -1 (+1) is the month before (after) the event month 0. The total excess bond return is the cumulative excess return over the month 0 and month +1. Neither excess return of month 0 nor that of month +1 per se is able to capture the total stockholder response to a bank loan covenant violations, because the violation filing date is always on the last day of month 0 and it is uncertain whether the monthly price P0,m reflect the news of violations or not. Two methods are used to calculate daily excess stock returns. First, daily excess stock returns are measured against the Carhart four factor model, which is estimated using daily data in previous 12 months of the bank loan covenant violation filing date. Alternatively, excess stock return is calculated as daily stock returns less CRSP daily market value weighted returns. 11

12 We also use the Gompers, Ishii, and Metrick index (G-index) to test influence of possible corporate governance improvement after violations on association between stock and bond reactions. G-index is based on the number of antitakeover provisions in a firm s charter and measures managerial entrenchment. Therefore, it is a negative index for good corporate governance because takeover itself is supposed to improve the firm s corporate governance. G- index is reported every two or three years from 1990 by RiskMetrics database. 4. Empirical Results In this section, we first investigate bondholder reactions to bank loan covenant violation events using daily bond returns from Bloomberg, and then do robustness tests using monthly bond data from Mergent/Moody s bond record and daily bond data from TRACE. We also examine stockholder reactions for all event samples using daily excess stock returns. Evidence indicates the time effects on investor reactions and evolution in bank loan covenants. Last, we investigate the association between shareholder and bondholder reactions and test effects of managerial entrenchment on their association. A. Excess bond returns Daily excess bond returns are computed as the difference between daily average bond return (change in price plus accrued interest) and daily average index return. Table 1 shows the time period effect on reactions of bondholders to bank loan covenant violations. From 1997 to 2002, bond price reactions are negative while they are positive after The sample is also grouped into below investment and investment according to the ratings of representative bonds. We find that bondholder excess returns are more positive in the group of 12

13 below investment bonds after In Panel C, Table 1, we put a restriction on bond illiquidity in order to exclude effects of illiquidity on bondholder reactions. Specifically, bonds included are required to be traded at least for one fifth of the total trading days in the current and following month of violation filing date, that is, 8 days. For example, if there is a bank loan covenant violation on May 31, 2006, but the representative bond is traded only on five business days in May and June, this observation will be excluded. In addition to liquidity restriction, event window in Panel D is required to be no longer than 8 trading days in order to exclude other noises involved. We can see that bond reactions become more significant after the liquidity restriction and event window restriction are applied. Since bonds are traded less frequently than stocks, it is common that some bonds do not have any transactions on a certain trading day. Therefore, the length of event window could be different for individual event observations. According to Panel A, Table 1, the average length of event window is 4.41 trading days in Panel C and 2.58 trading days in Panel D. The average daily excess bond return over 4.41 trading days for the subsample of below investment bonds from 2003 to 2008 is 8.66 bps in Panel C, that is, ( ) -1 = bps ( ( ( ) ( ) -1 = ) in Panel D. = bps). Similarly, the total bondholder reaction is bps The positive excess bond return in Panel C and Panel D is not only statistically significant but also economically significant, compared with previous studies. Billet, Mauer and Zhang (2010) find that the excess bond return around the first appearance of option and /or restricted stock grants is -112 bps for the two month period 0 and period +1. That is, bps per day ( 1/40 ( ) -1=2.82 bps). Maxwell and Stephens (2003) find that the abnormal bond returns to 13

14 the announcement of spin-off are 29 bps for a month. In contrast, we find greater bondholder reactions over a much shorter event window (38.25 bps over 4.41 days). Maxwell et al. (2009) use daily transaction data in TRACE and find that cumulated abnormal bidder return (CAR) is - 20 bps for a three-day event window (or 7 bps per day). Last, Fu and Zhang (2011) document 89 bps abnormal bond return over the five-day window (or 18 bps per day) to additional covenant restrictions introduced by a new bank loan. The positive reaction of existing bond holders may look counterintuitive at first sight since the bank loan violations could signal poor financial performance and precede payment defaults, which harm debt holders benefits. However, as discussed above, loan covenant violations also give private lenders an option to step in and take action before something really bad happens. The net effects of violations are determined by severity of current financial performance and improvements of corporate governance in the near future. Evidence shown in Panel B, C and D indicate that in 1990s, the net effects of violations are overwhelmed by the negative effects of financial performance deterioration, while the positive effects of corporate governance improvement become stronger in 2000s as more loan covenants are used as trip wires for banks to maintain close scrutiny. Our finding shows that the bond market views the bank loan covenant violations quite differently over time. In order to show that our finding is not data sensitive, Table 2 and Table 3 present the results of robustness tests using monthly bond data from Mergent/Moody s bond record ( ) and daily bond data from TRACE ( ), respectively. Consistent with the finding in Table 1, Table 2 reports marginally negative bond reactions to bank loan covenant violations in late 1990s and early 2000s. Specifically, the cumulative excess bond returns over event month 0 (the month of the violation filing date) and event month 1 (the following month after month 0) 14

15 for subsample of investment bonds are bps, or -5.6 bps per day, compared with bps in the 6 th column of Panel C, Table 1. Meanwhile, Table 3 shows significantly positive bond reactions to bank loan covenant violations from 2002 to 2008 using TRACE. And the positive daily excess bond returns is larger for the below investment bonds. B. Excess stock returns Table 4 reports the excess stock returns on the next day of violation filing date over The first five columns use the Carhart four factor model as the benchmark while the last five columns use the value-weighted market returns as the benchmark to compute excess returns. We find that the stock reaction is more negative in recent years, while it is marginally negative in , and even marginally positive in This finding infers that the stock market views the bank loan covenant violations differently over time as well as the bond market does. As for the negative shareholder reactions, there are two possible explanations. First, the control rights shift to creditors after violations hurt shareholders benefits. Alternatively, bank loan violations signal deterioration of firm performance. In order to distinguish the two explanations, we need to test the association between stockholder and bondholder reactions. If they are positively correlated when the bondholders have positive reactions, it is more likely that negative shareholder reactions derive from the control rights shift to creditors after violations. If the association between stockholder and bondholder reactions is positive when the bondholders have negative reactions, it is more likely that stockholders negatively respond to the bad news about firm fundamental changes. We will discuss it more in Section D. 15

16 C. The evolution in use of debt covenants In the previous two sections, we find significantly positive bond market reactions and significant negative stock market reactions to bank loan covenant violations in 2000s, but marginally negative bond market reactions and marginally positive stock market reactions in late 1990s. The time effects shown in our findings indicate possible evolution in use of bank loan covenants. Figure 1 presents the average number of bank loan financial covenants that US nonfinancial public firms with private debt are subjected to over Dealscan Database records 15 different types of financial covenants. A firm is considered to be subjected to one covenant, if the covenant exists in any bank loans outstanding at the end of each calendar year. The sample includes 6,524 unique firms and 37,426 firm years. We can see that the average number of financial covenants faced by US public firms rose sharply in 1990s, and stayed above 2 in 2000s. If banks use covenants as trip wire, which let them step in after covenant violations and take actions to protect their own interests, it is likely for banks to increase the number of debt covenants first. Admittedly, it is also possible that the rising number of debt covenants simply responds to changes of basic firm characteristics over time, and it is the latter factors that affect the investors market response to bank loan violations over time. In order to test this possibility, we control for firm characteristics based on the accounting information at the most recent fiscal year end in Table 6, and use total excess bond returns as the dependent variables in the first four columns; total excess stock returns in the last four columns. If this explanation is true, the difference of investors reactions to bank loan covenant violation could be explained by control variables and we should not find significant year dummies. However, from Table 6, we can see that the year 16

17 dummies are significantly positive for bondholder responses and significantly negative for shareholder responses. Specifically, the bond excess returns to bank loan covenant violations are 0.54% greater after 1999; the stock excess returns are 0.51% smaller after Obviously, the time effects cannot be totally explained by different size, leverage and market-to-book ratios over time. It is more likely that banks gradually and actively use more and/or tighter covenants to play an active role in corporate governance and the evolution of use in bank loan covenants affect both bond holders and stockholders in recent years. D. The association between stockholder and bondholder reactions Although we find positive bond reactions and negative stock reactions to bank loan covenant violations in 2000s, it is not clear how they are related to each other. Table 7 reports the Pearson correlation coefficients between market reactions of shareholders and bondholders to bank loan covenant violations. The total excess bond return is equal to [( P1 Accrued interest ) / P0] (1 R ) N M index, where N is the number of trading days between P1 and P0, M is the number of trading days of the violation month, and Rindex is the Lehman Brother monthly bond index return from DataStream. P1 is the first available bond price after the violation filing date while P0 is the last available bond price before the violation filing date. The total stockholder reactions are the cumulative excess returns between dates of P0 and P1. We can see that total excess stock returns and total excess bond returns are positively related in more recent years, especially when the bond reactions are positive. Specifically, the correlation coefficient is 0.38 during 2003 and 2008 when excess bond returns are positive. In contrast, when the bond reactions are negative, we do not find any significant correlation between stock market and bond market reactions. This finding is consistent with the trip wire hypothesis. Once the bank loan covenant is violated, 17

18 banks step in and exert formal and informal influence on the firm. Positive bond excess returns stand for the powerful influence banks may have. Synergy effects after violation make stock market and bond market reactions positively related to each other. Our results are robust to different benchmarks used to compute excess stock returns. Although correlation analysis is a useful diagnostic tool, it does not control other factors. Regression models in Table 8 use many individual firm characteristics as control variables. The dependent variable in the regression model is excess stock dollar returns and our interested independent variable is excess bond dollar returns. The excess stock dollar return is computed as the product of the total excess stock return based on the Carhart four-factor model and the market value of equity at the end of month preceding the violation filing date. The excess bond dollar return is computed as the product of the total excess bond return and the book value of long-term debt at the most recent fiscal year end. Both excess dollar returns are scaled by the total capital of the securities and converted into percentages. After2002 and After1999 are dummies that indicate whether the violations occur after 2002 and 1999, respectively. Therefore BCAR After2002 captures the association between excess stock and bond returns over 2003 to 2008 while BCAR (1 - After2002) captures the association between excess stock and bond returns over 1997 to The first 5 columns in Table 8 show that the relation between stockholder and bondholder reactions is significantly positive in more recent years. According to Column 3, one dollar increase of bondholder wealth is associated with 68 cents increase of stockholder wealth. The positive association supports our hypotheses that both bondholders and stockholders benefit from the influence exerted by private debt holders after bank loan covenant violations in 2000s. Meanwhile, we find that the relation between shareholder and bondholder reaction is 18

19 insignificant in 1990s. The time effects on stock market and bond market association also reflect the evolution of use in bank loan covenant, which we discussed in the previous section. Last, we use the Gompers, Ishii, and Metrick index (G-index) to test influence of managerial entrenchment on the association between stock and bond reactions. When the firm with bank loan covenant violations has great managerial entrenchment, the influence exerted by banks after covenant violations could be compromised. In this case, the association between stock market and bond market reactions could be larger if the firm has good corporate governance before violations. On the other hand, firms with bad corporate governance have larger room for improvement and could be more sensitive to banks efforts. In this case, the association between stock market and bond market reactions could be larger if the firm has bad corporate governance. In order to distinguish the two explanations, in Column 6, Table 8, we add governance measure and its interaction with total excess bond dollar returns to the regression model. The dummy governance is equal to 1 if the Gompers, Ishii, and Metrick index of the firm is below the median of the sample. Similarly, BCAR Governance captures the association between excess stock and bond returns when the firm has good corporate governance, while BCAR (1 - Governance) captures the association between excess stock and bond returns when the firm has bad corporate governance. Column 6 includes bank loan covenant violations in 2000s only. The regression results show that one dollar increase of bondholder wealth is associated with one dollar increase of stockholder wealth, when the firm has good corporate governance. And the association between stock market and bond market is insignificant, when the firm has bad corporate governance. This finding indicates that great managerial entrenchment hampers banks progress to improving firms performance, rather than offers creditors a chance to make greater difference. 19

20 5. Conclusions This paper examines stock and bond price reactions to new bank loan covenant violations during the period We find positive excess bond returns around the filing date in 2000s. This evidence supports the hypothesis that banks use covenants as trip wires; the violations offer creditors an option to step in and take actions that promote both bondholder and shareholder interests. In contrast, we document insignificant or opposite response of bondholders and shareholders in 1990s. This finding indicates the evolution in bank loan covenants over time. We demonstrate that the average number of financial covenants on US public firms rose sharply in 1990s and stayed above 2 in 2000s. The systematical change of covenant appliance infers that banks gradually use more and/or tighter covenant, and play an active role in corporate governance after violations. In addition, negative stockholders reactions are positively correlated with bondholders reaction in more recent years, reflecting banks positive influence on corporate governance after bank loan covenant violations. We also find managerial entrenchment decreases banks influence. 20

21 References Altman, E.I., A. Gande and A. Saunders, 2010, Bank Debt versus Bond Debt: Evidence from secondary market prices, Journal of Money, Credit and Banking 42, Bessembinder, H., K.M. Kahle, W.F. Maxewell and D. Xu, 2009, Measuring abnormal bond performance, Review of Financial Studies 22, Billet, M.T., D.C. Mauer and Y. Zhang, 2010, Stockholder and bondholder wealth effects of CEO incentive grants, Financial Management 39, Billett, M.T., T.D. King and D.C. Mauer, 2004, Bondholder wealth effects in mergers and acquisitions: New evidence from the 1980s and 1990s, Journal of Finance 59, Chava, S. and M.R. Roberts, 2008, How does financing impact investment? The role of debt covenant, Journal of Finance 5, Campbell,T.S., W.A. Kracaw, Information production, market signaling, and the theory of intermediation. Journal of Finance 35, 863Ð882. Datta, S., M. Iskandar-Datta and A. Patel, 1999, Bank monitoring and the pricing of corporate public debt, Journal of Financial Economics 51, Dichev, I.D., and D.J. Skinner, 2002, Large-sample evidence on the debt covenant hypothesis, Journal of Accounting Research 40, Esmer, B., 2010, Are creditors able to control managerial risk taking after covenant violations? working paper, University of Iowa. Fama, E.F., 1985, What s difference about banks? Journal of Monetary Economics 15, Park,C., 2000, Monitoring and Structure of Debt Contracts, Journal of Finance 55, Ramakrishnan, R.T.S. and A.V. Thakor, 1984, Information reliability and a theory of financial intermediation, Review of Economic Studies 51, Roberts, M. and A. Sufi, 2009, Control rights and capital structure: An empirical investigation, Journal of Finance 64, Maxwell, W.F. and R. Rao, 2003, Do spin-offs expropriate wealth from bondholders? Journal of Finance 58, Simpson, D.B., 1973, The Drafting of Loan Agreements: A Borrower s Viewpoint, Business Lawyer 29,

22 Maxwell W.F. and C.P. Stephens, 2003, The wealth effects of repurchases on bondholders, Journal of Finance 58, Nini, G., D.C. Smith and A. Sufi, 2012, Creditor control rights, corporate governance, and firm value, Review of Financial Studies, Nini, G., D.C. Smith and A. Sufi, 2009, Creditor control rights and firm investment policy, Journal of Financial Economics 92, Whitehead, C.K., 2009, The evolution of debt: covenants, the credit market, and corporate governance, Journal of Corporation Law 34: Fu, H. and J. Zhang, 2011, Debt covenants and risk taking, working paper, University of Southern California. 22

23 Table 1. Daily excess bond returns (in basis points) to loan covenant violations based on daily bond prices from Bloomberg Daily excess bond returns (in basis points) are computed as the difference between a bond s daily average return (change in price plus accrued interest) and the Lehman Brother daily average bond index return. Specifically, the excess return is 1 1 equal to [( P1 Accrued interest ) / P0] N (1 R ) M index, where N is the number of trading days between P1 and P0, M is the number of trading days of the violation month, and Rindex is the Lehman Brother monthly bond index return from DataStream. P1 is the first available bond price after the violation filing date while P0 is the last available bond price before the violation filing date. If a firm has multiple bonds, only one representative bond with longer maturity, larger amount outstanding and less security is included. The full sample is winsorized at 1% tails. In Panel C, bonds included are required to be traded at least for one fifth of the current month of violation filing date and the following month of violation filing date, that is, 8 trading days. In Panel D, an additional requirement is that event window should not be longer than 8 trading days. The significance level of the median is based on the Wilcoxon signed-rank test. P-values are in parentheses. *** indicates significance at the 0.01 level; ** indicates significance at the 0.05 level;* indicates significance at the 0.10 level. Panel A. Descriptive statistics of daily excess bond returns Mean Median StdDev Min Quartile1 Quartile3 Max Average length of event windows (trading days) before winsorization Obs winsorized at 1% (Panel B) winsorized at 1% ; traded at least for 8 days (Panel C) winsorized at 1%; traded at least for 8 days; event window no greater than 8 days (Panel D) Panel B. t-tests and the Wilcoxon signed-rank tests among different sample/subsample winsorized at 1% tails Below Investment Below investment Investment Full sample investment Mean (0.79) (0.70) (0.90) (0.47) (0.26) (0.42) (0.14) (0.98) (0.86) Median (0.34) (0.29) (0.95) (0.81) (0.17) (0.83) (0.14) (0.94) (0.99) Obs

24 Panel C. t-tests and the Wilcoxon signed-rank tests among different sample/subsample winsorized at 1% tails (bonds are required to be traded at least for 8 trading days in event month 0 and +1) Below Investment Below investment Investment Full sample investment Mean ** (0.75) (0.47) (0.54) (0.21) (0.11) (0.28) (0.03) (0.56) (0.75) Median * ** ** (0.14) (0.06) (0.64) (0.70) (0.03) (0.96) (0.02) (0.51) (0.98) Obs Panel D. t-tests and the Wilcoxon signed-rank tests among different sample/subsample winsorized at 1% tails (bonds are required to be traded at least on 8 trading days in event month 0 and +1; the days of event window, N, is no greater than 8) Below Investment Below investment Investment Full sample investment Mean ** 7.15* ** 10.23** (0.89) (0.78) (0.48) (0.03) (0.08) (0.04) (0.02) (0.46) (0.75) Median * 4.09** ** (0.40) (0.20) (0.54) (0.10) (0.03) (0.18) (0.01) (0.04) (0.99) Obs

25 Table 2. Monthly excess bond returns (in basis points) to loan covenant violations based on monthly bond prices from Mergent/Moody s manual Monthly excess bond returns (in basis points) are computed as the difference between a bond s monthly total return (change in price from Mergent/Moody s manual plus accrued interest) and the Lehman Brother monthly bond index return from DataStream. Event month 0 is the month of violation filing date and event month +1 is the next month of violation filing date. If a firm has multiple bonds, only one representative bond with longer maturity, larger amount outstanding and less security is included. The significance level of the median is based on the Wilcoxon signed-rank test. P-values are in parentheses. *** indicates significance at the 0.01 level; ** indicates significance at the 0.05 level; * indicates significance at the 0.10 level. Panel A. Descriptive statistics Before the sample is winsorized/trimmed Mean Median StdDev Min Quartile1 Quartile3 Max Obs Excess bond returns over event month 0 and , , , Excess bond returns over event month , , , Excess bond returns over event month , , , After the sample is winsorized at 1% tails (Panel B) Excess bond returns over event month 0 and , , , Excess bond returns over event month , , , Excess bond returns over event month , , , After the sample is trimmed at 1% tails (Panel C) Excess bond returns over event month 0 and , , , Excess bond returns over event month , , , Excess bond returns over event month , , Panel B. t-tests and the Wilcoxon signed-rank tests among different sample/subsample winsorized at 1% tails Excess bond returns over event month 0 and +1 Excess bond returns over event month 0 Excess bond returns over event month +1 Below Below Below Full sample investment Investment Full sample investment Investment Full sample investment Investment Mean ** (0.13) (0.28) (0.03) (0.45) (0.48) (0.71) (0.36) (0.66) (0.14) Median * * * *** (0.10) (0.28) (0.10) (0.80) (0.49) (0.25) (0.06) (0.33) (0.00) Obs Panel C. t-tests and the Wilcoxon signed-rank tests among different sample/subsample trimmed at 1% tails Excess bond returns over event month 0 and +1 Excess bond returns over event month 0 Excess bond returns over event month +1 Below Below Below Full sample investment Investment Full sample investment Investment Full sample investment Investment Mean ** (0.13) (0.29) (0.03) (0.50) (0.54) (0.71) (0.18) (0.40) (0.14) Median * * ** *** (0.10) (0.29) (0.10) (0.99) (0.67) (0.25) (0.04) (0.28) (0.00) Obs

26 Table 3. Daily excess bond returns (in basis points) to loan covenant violations based on daily bond prices from TRACE Daily excess bond returns (in basis points) are computed as the difference between a bond s daily average return (change in price from TRACE plus accrued interest) and the Lehman Brother daily average bond index return. Specifically, the 1 1 N M 1 0 excess return is equal to [( P Accrued interest ) / P ] (1 R index ), where N is the number of TRADING days between P1 and P0, M is the number of TRADING days of the violation month, and R is the Lehman Brother monthly bond index return from DataStream. P1 is the first available bond price after the violation filing date while P0 is the last available bond price before the violation filing date. If a firm has multiple bonds, the equal weighted excess return is used in the first three columns of Panel B and C, and the excess return of the representative bond is used in the last three columns of Panel B and C. The significance level of the median is based on the Wilcoxon signed-rank test. P-values are in parentheses. *** indicates significance at the 0.01 level; ** indicates significance at the 0.05 level;* indicates significance at the 0.10 level. index Panel A. Descriptive statistics Equal weighted excess returns of multiple issues are used Mean Median StdDev Min Quartile1 Quartile3 Max Obs Daily excess bond returns before winsorized/trimmed , Daily excess bond returns winsorized at 1% tails Daily excess bond returns trimmed at 1% tails Representative excess returns of multiple issues are used Daily excess bond returns before winsorized/trimmed , Daily excess bond returns winsorized at 1% tails Daily excess bond returns trimmed at 1% tails Panel B. t-tests and the Wilcoxon signed-rank tests among different sample/subsample winsorized at 1% tails The equal weighted excess return is taken for each event Full sample Below Investment The representative bond is chosen for each event Below Investment investment Full sample investment Mean 10.44* 15.46** * 17.90** (0.06) (0.03) (0.42) (0.09) (0.03) (0.49) Median * 3.29* 4.69 (0.18) (0.18) (0.71) (0.09) (0.07) (0.86) Obs Panel C. t-tests and the Wilcoxon signed-rank tests among different sample/subsample trimmed at 1% tails The equal weighted excess return is taken for each event The representative bond is chosen for each event Below Investment Below Investment Full sample investment Full sample investment Mean 7.62* 10.58* ** 14.49** (0.08) (0.06) (0.77) (0.05) (0.03) (0.97) Median * 2.88* 5.27 (0.17) (0.23) (0.55) (0.08) (0.09) (0.58) Obs

27 Table 4. Excess stock returns (in percent) to loan covenant violations based on daily stock returns from CRSP This table reports excess stock returns (%) on the following day of bank loan covenant violation filling date (event day +1) for different sample/subsample. Two methods are used to calculate excess stock returns (ECAR): (1) ECAR1 is based on the Carhart four factor model, which is estimated using daily data in previous 12 months of the bank loan covenant violation filing date; (2) ECAR2 is calculated as stock returns less CRSP market value weighted returns. The excess stock returns are winsorized at 1% tails. The significance level of the median is based on the Wilcoxon signed-rank test. P- values are in parentheses. *** indicates significance at the 0.01 level; ** indicates significance at the 0.05 level;* indicates significance at the 0.10 level. Panel A. Descriptive statistics of ECAR1 and ECAR2 for new violations Mean Median StdDev Min Quartile1 Quartile3 Max Obs ECAR1 over event day ,530 ECAR2 over event day ,530 Panel B. t-tests and the Wilcoxon signed-rank tests among different sample/subsample winsorized at 1% tails ECAR1 based on the Carhart four factor model ECAR2 based on value-weighted market returns Full sample Full sample Mean * 0.41** *** -0.26* -0.26** *** (0.65) (0.26) (0.08) (0.03) (0.24) (0.01) (0.06) (0.01) (0.13) 0.00 Median ** ** -0.26*** -0.35*** -0.16*** (0.30) (0.83) (0.01) (0.16) (0.02) (0.00) (0.00) (0.00) (0.89) (0.00) Obs 3,530 2,393 1,137 1,132 2,398 3,530 2,393 1,137 1,132 2,398

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