Interest Rates and the Design of Financial Contracts
We show that variation in short-term nominal interest rates produces an endogenous response in the design of and commitment to corporate loan contracts. Interest rates are negatively related to the cash flow rights and positively related to the control rights granted to creditors. An implication of this contractual response is a sharp increase in the ex post renegotiation of contracts originated in low interest rate environments, as well as a muted effect of interest rate variation on the cost of debt capital. Our findings illustrate how the design of financial contracts in practice reflects a multi-dimensional tradeoff among contract features that aligns incentives and apportions risk among the contracting parties in a state-contingent manner.
We thank Patrick Bolton, Urban Jermann, Craig Leonard, Mark Mitchell, Christian Opp, Bill Schwert, and Daniel Streitz; seminar participants at the University of British Columbia, University of Nebraska-Lincoln, University of Southern California, and the Wharton School; and participants at the Chicago Junior Finance and Macro Conference, the Conference on Financial Frictions at Copenhagen Business School, and the Washington University Corporate Finance Conference for helpful discussions. We also thank Evan Friedman and Derek Gluckman of Moody's Investors Service for providing data on loan covenant quality, and Bilge Yilmaz for aid in acquiring leveraged loan data. We gratefully acknowledge financial support from the Jacobs Levy Equity Management Center, the Rodney L. White Center, and the Wharton Financial Institutions Center. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.