Investment Opportunities and the Design of Debt Securities

Abstract

We investigate whether convertibility provisions and restrictive covenants operate as substitute methods for reducing agency costs of debt. In a study of the 192 recent debt issues, we find that an issuer’s investment opportunities are negatively related to the presence of covenants and positively associated with the incidence of convertibility after controlling for investment opportunities. The results support an interpretation that covenants impose costs by limiting mangers’ choices, leading firms that value managerial flexibility to prefer convertibility provisions as a method of reducing the agency costs of debt.