Debt Contracts and Loss Given Default Article Swipe
YOU?
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· 2019
· Open Access
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· DOI: https://doi.org/10.17615/x4wn-1v73
· OA: W658762497
This study explores how accounting information available to lenders at the contracting date shapes debt contracts by facilitating lenders' assessment of loss given default (LGD). LGD, defined as the percentage loss experienced per $1 of debt if default occurs, is closely related to the notion of liquidation value which is central to debt contracting theories. LGD, together with probability of default, determines expected credit loss and as such is a critical component of debt contract design. While a large literature examines probability of default, much less is known about the impact of expected LGD on contract design and the information set relevant to lenders in assessing LGD at debt origination. Using a sample of defaulted bonds, I find that a select set of accounting measures available at contract initiation, which is 47 months on average before the default event in my sample, possess significant power for predicting actual creditor losses at the subsequent default date. I then exploit this prediction model to construct an accounting-based measure of expected LGD for a large sample of bond issuances. I find that a one standard deviation increase in this measure is associated with a 58 basis point increase in the issuance date interest rate spread, incremental to probability of default. The positive relation between expected LGD and spread is higher when probability of default and managerial entrenchment are higher. Expected LGD is also associated with an increased probability of the debt being secured, having shorter debt maturity, and having a smaller debt size. These relations also hold for a sample of private loan issuances after controlling for financial covenant strictness, where I also find that higher expected LGD is associated with stricter financial covenants. Moreover, I find evidence that accounting systems that provide more precise information about equity value also provide more precise information about LGD, where the opposite holds for more conservative accounting.
