Douglas R. Emery

An empirical investigation of the role of indenture provisions in determining bond ratings

Abstract This paper documents the occurrence of indenture provisions of newly issued bonds and the relevance of these provisions to a bonds rating. A chronicle of the various combinations of restrictive covenants reveals that four covenant combinations account for over 90% of the issues. The evidence also suggests that convertibility of an issue vitiates stockholder-bondholder conflict because these issues have few, if any, restrictive covenants. Also, the indenture provisions of low rated, subordinated issues appear to reflect a concern about the underinvestment problem while the opposite holds for high rated, nonsubordinated issues. The addition of indenture provisions to a bond rating model is shown to create a model superior to previous rating models. This finding highlights the complex nature of the corporate financial contracting process. Consistent with past evidence, Moodys ratings are predicted more accurately than S&Ps ratings and split rated issues are predicted less accurately than commonly rated issues.