Research Brief: Senior Lenders Are Great, Until They’re Not
What Did The Study Look At?
Loan providers and bondholders have a complicated relationship. Both can provide capital to the same growing firms yet they are hardly equal in status. Loan providers such as big banks are considered senior lenders: they can design restrictive loan contracts with numerous covenants that are tied to financial performance. The bargaining power that comes from these covenants can be significant and either serve or undercut the interests of other creditors.
Bondholders are junior lenders; they are highly dispersed and, as such, must accept less favourable conditions. On the other hand, junior lenders benefit from the close monitoring that senior bank lenders typically exert on firms that borrow from them.
The focus of this study is on how junior lenders view the trade-off between monitoring benefits and creditor conflicts. Specifically, the researchers look at the effect of senior lender control on the pricing of new bond issues. The study is one of the first to document the influence of one type of debt contract’s terms on the pricing of another type of debt contract.
How Was The Study Designed?
The researchers hypothesized that monitoring by senior lenders would make a firm’s bonds less risky; bondholders would therefore require lower yield in the presence of strong senior lender control. But when senior lender control reaches a certain threshold, bond yield would rise due to the potential fallout from creditor conflicts. In this study, the measure of senior lender control was the number of bank loan covenants on a firm’s balance sheet. The bond issuance sample consisted of 4,754 public bonds issued by U.S. companies between 1992 and 2012.
What Did The Study Find?
- There was a U-shaped association between loan covenants and the bond yield spread. The first financial covenant added to a loan contract reduced the bond yield spread by 16 basis points (a basis point describes the percentage change in the value or rate of a financial instrument). By contrast, when there were more than three financial covenants, the increase in bond yield was an additional 31 basis points compared with the yield spread for firms whose loans have no financial covenants.
- The positive correlation between loan covenants and bond yield spread was greater for firms with strong corporate governance and high default risk and when the bondholders were dispersed.
What Do I Need To Know?
These results suggest that bondholders value the monitoring benefits from the first covenant added to a loan contract. But as the number of covenants increase, bondholders become increasingly concerned about potential losses arising from creditor conflicts and demand additional compensation as a result.
Bondholders are right to be concerned. While loan covenants can be useful tools for senior lenders, the researchers point to several ways they can be detrimental to other lenders. One is that if a covenant is violated, “senior loan lenders can immediately stop lending, terminate commitments, require accelerated payments, call for default, or even exert direct influence on corporate policies.”
Senior lenders may also urge the firm to delay interest or principal payments to bondholders when they come due.
Title: Senior Lender Control: Monitoring Spillover or Creditor Conflict?
Authors: Bo Li (Tsinghua University), Lynnette Purda (Smith School of Business), Wei Wang (Smith School of Business)
Published: Paper available for download here