Scandinavian Working Papers in Business Administration

Discussion Papers,
Norwegian School of Economics, Department of Business and Management Science

No 2011/1: The Defeasance of Control Rights

Carsten Bienz (), Antoine Faure-Grimaud () and Zsuzsanna Fluck ()
Additional contact information
Carsten Bienz: Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration, Postal: NHH , Department of Finance and Management Science, Helleveien 30, N-5045 Bergen, Norway
Antoine Faure-Grimaud: London School of Economics, Postal: London School of Economics, Houghton Street, London WC2A 2AE, United Kingdom
Zsuzsanna Fluck: Broad College of Business, Michigan State University, Postal: Broad College of Business, 319 Eppley Center, Michigan State University, East Lansing, MI 48824, USA

Abstract: We analyze one frequently used clause in public bonds called covenant defeasance. Covenant defeasance allows the bond issuer to remove all of the bond's covenants by placing the remaining outstanding payments with a trustee in an escrow account to be paid out on schedule. Bond covenants are predominantly noncontingent, action-limiting covenants. By giving the issuer an option to remove covenants, noncontingent control rights can be made state-contingent even when no interim signals are available. We provide a theoretical justi cation for covenant defeasance and show empirically that such a clause allows for the inclusion of more covenants in public bond issues. In line with the model's prediction, our empirical analysis documents a 13-25 basis points premium for defeasible bonds. This premium amounts to an annual saving of about $1m per year, or $11m over the lifetime of an average bond.

Keywords: Bonds; Covenants; Defeasance; Renegotiation

JEL-codes: D86; G12; G32

46 pages, January 28, 2011

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