Are restrictive covenants effective mechanisms in mitigating agency problems? Is the magnitude of the increase in the cost of debt due to agency problems non-trivial? We tackle these questions using a large dataset of public bonds. Contrary to the view that restrictive covenants in public bond contracts are standard boilerplates that serve little purpose, we find significant benefits in terms of reduction in the cost of debt associated with covenants. Restrictions on investment activities or issuance of higher priority claims reduce the cost of debt by about 35–75 basis points. These findings suggest that investors view bond covenants as important instruments in mitigating agency problems, and an increase in the cost of debt due to agency problems could be substantial. Additionally, we find that high growth firms and firms with low probability of default are less likely to include covenants suggesting that the costs of covenants outweigh benefits for these types of firms.

This paper examines the influence of capital structure change on the value creation from asset sales. We find significant positive equity and debt excess returns are concentrated in the subsample of highly leveraged firms that use the proceeds to retire debt. Low leverage firms display no consistent significant excess equity or bond returns. The existent literature has focused on efficiency redistribution, increase in focus, and access to capital for investment as the primary drivers of value creation from asset sales and agency costs as a major factor that mitigates this value creation. The evidence presented in this paper suggests that the primary driver of value creation is from capital structure change for highly leveraged firms.