The Value of Creditor Control in Corporate Bonds

Oğuzhan Karakaş is Assistant Professor of Finance at the Carroll School of Management at Boston College. This post is based on an article authored by Professor Karakaş; Peter Feldhütter, Assistant Professor of Finance at London Business School; and Edith S. Hotchkiss, Associate Professor of Finance at the Carroll School of Management at Boston College.

In our article, The Value of Creditor Control in Corporate Bonds, recently published in the Journal of Financial Economics, we introduce a measure that captures the premium in bond prices that is due to the value of creditor control. We estimate the premium as the difference in the bond price and an equivalent synthetic bond without control rights that is constructed using credit default swaps (CDS) contracts. The main insight for the methodology is that CDS prices reflect the cash flows of the underlying bonds, but not the control rights. The premium we introduce captures the marginal value of control in a bond until the bond matures or—in the case of a payment default or bankruptcy—until the CDS contracts for that issuer settle, and hence is a lower bound for the control premium.

Why are creditor control rights valuable? Control shifts to creditors as the firm becomes distressed, particularly when the firm is closer to default or bankruptcy. From a legal perspective, the fiduciary responsibility of the board shifts to creditors as soon as the firm is in the “zone of insolvency.” Even if the firm is farther from insolvency, cash flow shortfalls such that a firm violates a covenant or misses a scheduled debt payment trigger control rights for debtholders. A natural question that arises is why control should be priced in any security (equity or debt). Theoretically, potential conflicts or disagreements among investors about how to run the firm in a world with incomplete contracts make control valuable. The value of control depends on the probability of a disagreement situation arising and its economic significance, and hence is time varying.

How do bondholders exercise control rights? Even when firms are not near distress, certain corporate actions—such as changes to financings, pledges of collateral, asset sales, or acquisitions—can require the consent of a specified percentage of bondholders. Further, a decline in firm value creates incentive for creditors to exercise their control rights—such as covenant violations giving the creditors the ability to intervene in managerial decisions. Closer to or in default, control arguably matters most. As firms become seriously distressed, creditor control can affect managerial decisions in a way that impacts the value of the debt claims, the form of a restructuring that might occur, and the distributions to creditors in the event of a restructuring. In many cases, a default leads to a change in control where the creditors become the new owners of the firm through distributions of stock in a restructuring.

Using a sample of 2,020 publicly traded bonds of 963 U.S. companies over 2002-2012, we find our premium is close to zero for bonds of high credit quality firms, but monotonically increases as the credit rating declines for non-investment grade firms. Further, we show that the premium increases as firms near important credit events, such as defaults, bankruptcies, and covenant violations. In the cross-section, the increase around defaults is higher for firms with more tangible assets, and for securities that are pivotal (such as fulcrum bonds) to changes in control. Overall, we find the premium is positive and economically significant when creditor control rights are valuable (e.g., over 6% of the bond price by the time of default or bankruptcy, and 1.5% around covenant violations).

Our results are robust to controls for both CDS and bond liquidity, as well as to other factors recently suggested to impact the CDS-bond basis such as crisis periods, funding risk, counterparty risk, haircuts (collateral quality), cheapest-to-deliver option for the CDS contract, and informational efficiency of CDSs with respect to bonds. Further technical issues regarding the CDS, such as the maturity of securities, auctions, deviation from par values, and CDS quote quality do not drive or affect our findings.

Our article contributes to the literature on corporate governance and in particular to that on creditor rights. To our knowledge, this is the first article to propose a measure reflecting the value of control rights in debt securities, which is well developed in the theoretical literature. This study also contributes to the CDS-bond basis literature as it proposes a new explanation for some of the empirically documented violations of the no arbitrage relation for the CDS and bond spreads. To our knowledge, we are also the first paper to document the behavior of both bond and CDS liquidity around important credit events including defaults. Our methodology can be useful in other studies in corporate finance/governance, law, and economics focusing on creditor control.

The full article is available for download here.

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