- Slides: 8
Discussion of Mansi-Qi-Wald: Debt Covenants, Bankruptcy Risk, and Issuance Costs Wuhan, July 2011 Moqi Xu INSEAD/LSE
Bankruptcy risk and covenants Problem Does covenant use reduce bankruptcy risk? ( <0) How can we isolate causal effects from selection?
Bankruptcy risk and covenants Problem Does covenant use reduce bankruptcy risk? ( <0) How can we isolate causal effects from selection? The paper Unpredicted covenants reduce bankruptcy risk: <0 Predicted covenants are positively related to bankruptcy risk ( >0)
Causality Problem The paper Comment • Smith-Warner: Covenants alleviate agency conflicts between bondholders and shareholders • Prediction: Firms with more potential conflicts have more covenants • Here: Riskier firms have more potential for conflicts This seems to be the point of view of the bondholder. If the firm takes a project that reduces risk but is not observable, won’t it prefer more covenants (with a lower yield)?
Endogeneity “As the bankruptcy events occur after the bond is issued, endogeneity is not a serious concern in this specification” (p. 10) Problem The paper • Omitted variable: no bankruptcy risk in covenent prediction • Endogeneity: and are correlated Comment Why not use an instrumental variable approach? It seems that you use variables to predict covenant use that fulfill the exclusion restriction (state laws, herding)
Covenants in detail Covenants The paper Comment Objective of covenants: Reduce bankruptcy risk and bankruptcy costs to bondholders Different types: payment, borrowing, asset, stock, default, antitakeover, profit, rating decline… • Counts covenants to an index • Splits the index into sub-indices as well as single covenants • Stock issuance covenants and rating decline puts differ from the others: they do not reduce bankruptcy risk It would be nice to see more on risk vs. cost of bankruptcy This could also help to address the endogeneity problem.
Issuance costs The paper Comment • Finding: fees charged by the investment bank for placing the issue are higher when there are more covenants • Potential explanations: • Administrative costs? No, the effect of subindices differ • Legal costs? No, no effect on class actions • Sales effort? No, selling concessions increase less than other underwriting fees • Risk of issue? Yes, relation disappears if controlling for bond rating • Are some covenants are more complex than others? • Other legal disputes than class actions? • Why not test placement risk explicitly? • What about yields?
Miscelleanous • “Following Welch (1992) … we posit that the use of covenants may be consistent with informational cascades or herding” – do you control for information asymmetry? (Idiosyncratic risk is maybe too much driven by volatility? ) • M/B ratio of 1. 2