Supply of credit and corporate bond covenants

We study whether shocks to the supply of capital affect bond covenant structures using the collapse of Drexel Burnham Lambert, Inc. and the subsequent regulatory changes as an exogenous contraction in the supply of speculative-grade credit around 1989. We find that speculative-grade firms increase their covenant use significantly more than the investment-grade firms in the post1989 period. This result is robust to using alternative control groups such as using only the BBBrated firms, unrated firms, and employing matched sample analysis. Consistent with a supply effect, the increase in covenant use is higher for firms with high costs of switching to alternative sources of funds and high dependence on external finance. Overall, our results suggest that shifts in credit supply affect not only the debt amounts but also the bond covenant structures. Even contracting terms of firms with access to public debt markets are not immune to fluctuations in the supply of capital.