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The Journal of Real Estate Finance and Economics

Erschienen in:

01.05.2016

The Role of Debt Covenants in the Investment Grade Bond Market – The REIT Experiment

verfasst von: Yongheng Deng, Erik Devos, Shofiqur Rahman, Desmond Tsang

Erschienen in: The Journal of Real Estate Finance and Economics | Ausgabe 4/2016

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Abstract

In general, investment grade bonds do not offer covenant protection. However, in the case of Real Estate Investment Trusts (REITs), investment grade REITs tend to include a covenant package that outlines limits on leverage and requires maintaining certain fixed charges and interest coverage ratios. This unique debt financing structure of REITs offers a natural environment to examine the importance and the need of debt covenants in the investment grade bond market. Our research aims to answer the following questions: 1. How common are debt covenants in the investment grade REIT bond market? 2. Are debt covenants binding in this market? 3. Do debt covenants affect the cost of debt? Our findings indicate that, in the REIT market, debt covenants are indeed common practice among investment grade REITs and, surprisingly, we find higher use of covenants by investment grade REITs compared to non-investment grade REITs. We show that debt covenants are seldom binding in this market, as investment grade REITs choose covenant provisions based on accounting ratios for which they seem to have enough slack. Finally, the cost of debt is lower when these investment grade REIT bonds are issued with covenants.

Vorheriger Artikel Related Party Transactions and Firm Value: Evidence from Property Markets in Hong Kong, Malaysia and Singapore

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For example, the increasing roles of shareholder activists and private equity firms are affecting the stability of the investment grade investment landscape, by triggering leveraged buy-outs, mergers, and share repurchases which favorably reward shareholders at the expense of debt-holders (Moody’s 2006).

This group of investors includes organizations such as AIG Investments, Black Rock Financial Management, CALPERS, Fidelity Investments, Franklin Templeton Fixed Income Group, ING Investment Management, PIMCO, TIAA-CREF, and the Vanguard Group.

See Sakowitz and Junewicz (2008) for details.

Interestingly, at good economic times, the argument for imposing less covenants extends to the non-investment grade bond market as investors are not worried when companies are healthy and the risk is low. Nonetheless, the sale of these so-called ‘covenant-lite’ loans sparks big debate among regulators and investors as the lack of lender protection poses even greater concern in the non-investment grade bond market (Alloway 2014).

“Analyzing The Size And Structure Of The U.S. Investment-Grade And Speculative-Grade Corporate Debt Market In 2013.” Standard & Poor’s Global Fixed Income Research (July 2013).

This interesting phenomenon originated when insurance companies started to invest into the REIT market. When insurance companies invest into the property market, they typically impose the property-level covenants associated with commercial mortgages. Accordingly, when a handful of insurance companies started to look at REIT as an investment vehicle, they also asked for same type of covenants that were associated with commercial mortgages on REIT loans (Olazabal and Arora 2012).

For example, Chava and Roberts (2008) and Nini et al. (2009) show that a firm’s investment declines sharply following covenant breaches. Roberts and Sufi (2009) find that technical default leads to a reduction of future debt issuance.

Our (unreported) results when using this definition are very similar and are available from the authors upon request.

We do not use the number of lenders because the distribution of this variable is highly skewed. Instead, we construct a dummy variable to measure the effect of multiple lenders when the number of lenders of a loan is greater than one. Nevertheless, measuring the variable with the number of lenders instead of a dummy variable does not alter our main findings.

The Dealscan-Compustat link file: http://finance.wharton.upenn.edu/~mrrobert/data_code.htm

Our number of REITs is comparable with that of Deng et al. (2011). They find 228 distinct REITs over the same period. The observed difference in sample size is mainly because of differences in the matching procedure.

To control for the effect of outliers, we winzorize all continuous variables used in the empirical analysis at the 1st and 99th percentiles.

We realize that market-to-book ratios are affected by the market capitalization of firms which in turn are related to the cost of debt. Hence, we drop the market-to-book variable and also take these ratios in log form in alternative analysis to ensure the cross-causality between the market-to-book ratios and the cost of debt does not bias our findings.

We do not include this unsecured dummy in our main analysis as it significantly reduces our sample size. Nonetheless, Table 8 shows that our empirical results remain intact with the inclusion of this additional variable.

The endogeneity test results are available upon request from the authors.

All these results are available upon request from the authors.

Alloway, T. (2014). Growth of ‘Cov-Lite’ Loans Sparks Debate. The Financial Times Limited, March 23. www.ft.com.

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Titel: The Role of Debt Covenants in the Investment Grade Bond Market – The REIT Experiment
verfasst von: Yongheng Deng
Erik Devos
Shofiqur Rahman
Desmond Tsang
Publikationsdatum: 01.05.2016
Verlag: Springer US
Erschienen in: The Journal of Real Estate Finance and Economics / Ausgabe 4/2016
Print ISSN: 0895-5638
Elektronische ISSN: 1573-045X
DOI: https://doi.org/10.1007/s11146-015-9511-6

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