RDP 2022-05: The Real Effects of Debt Covenants: Evidence from Australia 6. Conclusion

This paper studies the macroeconomic effects of debt covenants using a new dataset of corporate debt covenants in Australia. I first extend the strand of literature focusing on the consequences of covenant breaches by exploring the disciplining role of debt covenants. I find that firms exposed to debt covenants reduce their investment and staff expenses even in the absence of any breaches, suggesting that covenants can have substantive implications for firm behaviour even if rates of breach remain low. I then examine how the structure of covenants affects the transmission of monetary policy to real business activity. I find that interest coverage covenants, where the level of interest rates affects how much they bind, amplify the responses of investment and staff expenses to monetary policy shocks. By contrast, covenants that directly limit the stock of debt appear to dampen the transmission.

Interestingly, there seems to have been a compositional change in covenants over time among non-financial listed firms in Australia. The shift away from interest coverage covenants towards other types of covenants is in contrast with findings in the United States where the interest coverage share of debt covenants has stayed virtually constant since the late 1990s (Greenwald 2019). Using simple quantification, I find that the compositional change in covenants over time in Australia may have had a sizeable effect on the transmission of monetary policy to aggregate non-mining investment.

This potentially explains part of the surprising weakness in non-mining investment in Australia since the 2010s. The shift may have also made employment slightly less responsive to monetary policy. To the extent that the shift reflects a structural change, it has important implications for monetary policy. As such, future work should explore the potential causes of the shift in covenant composition.