Covenants and the Pricing of Private and Public Bonds

We investigate the pricing of private versus public placement bonds in the primary market and test the effect of covenants on yield spreads. The yield spread premium of 116 basis points is partially explained by credit risk but equally important, by covenants. We provide evidence of a U-shape effect of covenant intensity on spread, the downward sloping part explained by investment covenants, the upward sloping part by financing covenants. The use of covenants has as much explanatory power beyond credit risk as liquidity and market conditions together, providing direct evidence of firm’s willingness to pay for options providing renegotiation flexibility.