Investor Sentiment and Debt Contracting

Abstract

**Please note that the full text is embargoed until 08/01/2024** This study examines the impact of investor sentiment on loan spread and financial covenants in debt contracts. Periods of high investor sentiment generally result in pressure on loan spreads due to the ability to issue equity at lower cost. Thus, I conjecture that managers of borrowing firms as well as lenders may trade-off lower spreads against higher or more restrictive covenants during such periods. Therefore, high investor sentiment has two related effects on debt covenants: (i) it encourages higher and more restrictive covenants by lenders at contract inception and, consequently, (ii) it ensures a higher ex-ante probability of eventual covenant violations. Consistent with the conjectures, I find that investor sentiment is positively associated with the intensity and restrictiveness of financial covenants and negatively associated with spreads. Specifically, high investor sentiment periods are associated with higher covenants (performance covenants, capital covenants and covenants intensity) and lower spreads. Further analysis indicates that this relationship is more pronounced for financially constrained firms and for firms that exhibit a lower degree of timely loss recognition in accounting earnings. Additionally, I find that investor sentiment is positively associated with the ex-ante likelihood of covenant violations. Collectively, these findings highlight the importance of the role played by investor sentiment in debt contracting.