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What Are Debt Covenants And Why Are The Debt Covenant Are Heavily Used In Private Debt?

712 words - 3 pages

What are debt covenants? :Debt covenants are instruments available to lenders to limit the borrowers' action during the loan term. These agreements between companies and its creditors require companies to operate within the specific conditions of the loan agreements. They are negotiated during the debt structuring process and are different for every transaction. An example of the debt covenants is that if a company misses its interest payments (coupons), the bondholders may acquire the right put the company into liquidation. Further examples of "financial" covenants include maintenance of minimum working capital and debt service coverage ratios, maintenance of minimum net worth, restrictions ...view middle of the document...

The common agency problems occur when managers or shareholders who usually have more information about firms acts riskier to increase their earnings at expense of debt holders money. They may involve in benefit seeking activities that are detrimental for creditors. Consequently, following debt covenants, creditors may demand immediate payments if borrowers are in breach of covenants agreements (also known as technical defaults). Studies show that debt covenants violations are frequently in public debt market. Therefore, debt covenants are heavily used to prevent the negative effects of a technical default to the lenders. Second, debt covenants may include elements that prevent the asymmetric information problems. Generally, lenders are not fully informed about the financial statistics of the company to which they are borrowing. By requiring, for example some financial statements from the company through debt covenants, lenders may mitigate the asymmetric information problem. For this reason, debt covenants are also widely used in private debt market.[4: Graeme Pietersz, "Debt Covenants", accessed August 6, 2014, ][5: Mitchell Berlin and Loretta J. Mester, "Debt Covenants and...

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