The impact of debt covenants on earnings announcement returns

We study the impact of debt covenants on earnings announcement returns by creating 10 covenant groups and a covenant index using event-study methodology. We find that during bad news, whether it stems from a bad earnings surprise or a negative average market reaction, both the index and most covenant groups display a significantly negative impact on announcement returns. For good news, particularly when the market reaction is positive on average, we also observe a significantly positive effect from some covenant groups, but not the index. One exception is the debt issue restriction covenant which shows significant effects in the opposite direction of the market reaction. The strongest impact on returns comes mostly from debt-related covenants such as leverage tests, cross-default clause and debt issue restrictions. Among the merger-related (shareholder payout) covenants, poison put (share repurchase) exhibits the largest impact. Finally, we also show that regardless of firm characteristics, risk measures or exposure to information asymmetry, covenants have a negative impact on announcement returns for all firms when the news is bad. For the full sample and the good news subsample, however, we find that small, risky firms with high information asymmetry issues are rewarded by the market and vice versa.