AN EMPIRICAL-INVESTIGATION OF THE ROLE OF INDENTURE PROVISIONS IN DETERMINING BOND RATINGS

This paper documents the occurrence of indenture provisions of newly issued bonds and the relevance of these provisions to a bond's 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, Moody's ratings are predicted more accurately than S&P's ratings and split rated issues are predicted less accurately than commonly rated issues.