Abstract

A covenant is a particular clause in a firm's debt contract that restricts the firm's options and provides creditors with the right to enforce certain actions (e.g., early repayment) if the covenant is violated. According to the agency theory of covenants, if the benefits of implementing a covenant exceed the costs, then lenders will include covenants in their debt contracts. We investigate a new aspect of the discussion on covenants, namely, the tightness of a covenant. We provide a theoretical model of the optimal threshold for covenants in public and private debt agreements. We found a negative relationship between the costs of covenant violations and covenant strictness. Using a reduced form of the model, we find that the positive difference between public and private debt covenant thresholds holds only: i) for less risky firms, ii) for lower coordinated bondholders, and iii) for lower renegotiation costs for the bank compared to those of the bondholders.