Covenants, Interest Rates, and the Cost of Debt

In debt financing, borrowers' and lenders' misaligned preferences over risk-return tradeoffs create an agency cost that is jointly determined by interest rates and covenants. Under basic conditions, the optimal, cost-minimizing combination of the two is unique and, depending on borrower characteristics, can lie anywhere between low interest rates with strict covenants and high interest rates with loose covenants. Contrary to this fact, empirical research in accounting has frequently conflated low interest rates with efficient contracting and a low cost of debt. At the same time, predictable regularities in optimally designed debt contracts exist. The optimized cost of debt is concave and non-monotonic in profitability and leverage. Debt contracts are most efficient when leverage and profitability are inversely aligned, consistent with the empirically observed negative correlation between the two. If the borrower has greater scope than the lender to affect risk and return, low interest rates and restrictive covenants are optimal.