Stock and Bond Returns, Insider Trading and Debt Covenant Violation Disclosures

Abstract

This thesis investigates the effectiveness of debt covenant violations in applying disciplinary pressure onto management to protect bondholder wealth. By examining price behaviour for both bonds and stocks around debt covenant violation disclosures, I show that both parties earn positive abnormal returns in the 50 days following a covenant violation disclosure. The overall gains accrued by both parties for the entire event window depend on whether the violation is waived. Abnormal bond returns are relatively higher than abnormal stock returns when creditors are stricter in their enforcement of the non-waiver mechanism, with the reverse being true when violations are waived. I also show that firms with superior credit quality and profitability are more likely to receive a waiver.

I also examine if lagged bond prices can explain insider abnormal stock returns earned around covenant violations. I find no evidence of a bond price leading effect, instead showing that stocks lead bonds in the non-waiver sample. This supports the view that corporate insiders are able to use inside information gained during the covenant violation renegotiation process to earn abnormal returns in the stock market.