Debt Dilution, Debt Covenants, and Macroeconomic Fluctuations

Debt covenants are pervasive in debt contracts. To prevent the dilution of existing debt, most creditors set covenants of a maximum debt-to-earnings ratio for borrowing firms. In this paper, we embed debt covenants into a workhorse real business cycle model with defaultable long-term debt to study its macroeconomic implications. In our model, creditors penalize firms when covenants are violated. We show such a mechanism that covenants significantly reduce debt dilution and default over the business cycles. Furthermore, reduced debt dilution due to covenants also mitigates the debt overhang problem and thus boosts capital accumulation. Compared to counterfactual economies without covenants, the baseline economy with covenants experiences endogenous stabilization of macroeconomic shocks and higher levels of capital, output, and consumption.