We investigate the trading and yield effects of covenant-lite (cov-lite) high-yield bond contracts, which have a restricted (lite) set of covenants. The excluded covenants often are those that use accounting performance measures. Although much research has focused on the potential benefits of accounting as a basis for debt contracting, little is known about settings where it may be optimal to exclude accounting performance statistics from public debt contracts. We find that cov-lite high-yield bonds have a higher trading turnover and lower yield spreads. Our findings provide empirical support for theory, which predicts, for optimal bond covenant design, that a trade-off between improving trading ease versus enhanced investor protection needs to be managed. These results enhance our understanding of the limits of accounting’s role in (bond) contracting design.

The authors thank Bharat Sarath and Linda Myers (editors) and two anonymous referees for veryhelpful comments and suggestions. They also thank the comments of Wei-Ling Song (chair) and participants at the 2018 JAAF Conference

Covenants,Debt,Risk,Turnover,Trading volume,Control rights

• Economics and Business - Social Sciences