Abstract
This paper analyzes a regulatory intervention that ordered the inclusion of performance-based contractual terms (financial covenants) in public bonds purchased by institutional investors, with the aim of improving corporate governance exerted by creditors. Financial contracting theory suggests that debtors and creditors agree to incorporate restrictions in debt contracts when the costs to the firm stemming from lost flexibility are offset by a reduction in debt financing costs. A necessary condition, though, for these restrictions to have an effect on financing costs is that creditors are able and willing to monitor a borrower’s compliance and to act upon violation. I provide evidence that the exogenously imposed contractual structure introduced by regulation resulted in the use of covenants that are designed in an unbinding manner and are seldom violated. I conjecture that this is because of high monitoring and engagement costs faced by institutional investors, which discourage them from frequently renegotiating debt contract terms outside of bankruptcy.