Study: Transparency in the secondary bond market can lead to fewer restrictions for borrowing firms

By Hoyoun Kyung and Mahfuz Chy 

When companies borrow money, how their loans are structured depends on how much information potential lenders have about the borrowers’ current and future financial health. Previous studies have focused on characteristics of borrowing firms, such as financial reporting quality or uncertainty in firm fundamentals, as factors influencing loan terms.

However, in a recent study, we explore how transparency in the financial markets — specifically, the secondary corporate bond market — affects the use of debt covenants in private lending agreements.

The role of the bond market in shaping loan contracts

Understanding the impact of enhancements in bond market transparency on debt contract design is important for several reasons. While previous research has highlighted the benefits of bank screening and monitoring for other stakeholders, including bond investors, the role of the bond market in shaping bank loan contracts has been largely overlooked.

Additionally, while firm-level transparency is often based on an individual firm’s cost-benefit analyses, market-level transparency is not influenced by such considerations. Therefore, conclusions from prior studies about firms’ incentives for transparency may not directly apply to the effect of market-level transparency on debt contracting.

The secondary bond market is known to price and disseminate forward-looking information that anticipates borrowers’ default risk, risk-taking and moral hazard problems as well as potential changes in economic fundamentals. This market also reflects information about other material events that can impact a firm’s ability to service debt obligations, such as paying interests and principal. Previous research has shown that a reduction in information risk as borrowers and lenders enter into lending agreements can reduce the usefulness of debt covenants in private lending agreements.

However, whether improvements in the secondary bond market transparency affect private loan contract design remains an empirical question, as banks are sophisticated monitors with timely access to borrowers’ private information. That is, banks may find the information reflected in the secondary bond market to be less useful.

Gathering data using TRACE

Our study uses the staggered implementation of the Trade Reporting and Compliance Engine (TRACE) to capture enhancements in bond market transparency. TRACE is an automated system that assembles and disseminates all corporate bond transactions in the U.S. secondary over-the-counter (OTC) bond market.

Prior to the implementation of TRACE, post-transaction details were reported only to the parties directly involved in each trade, making the OTC corporate bond market more opaque. In an attempt to enhance bond market transparency, the Securities and Exchange Commission (SEC) approved the TRACE rule, mandating that all brokers and dealers registered with the SEC report transactions they facilitate for all TRACE-eligible corporate bond securities.

The beneficial effects of transparency

Our main finding is that treatment firms, which undergo transparency enhancements under the TRACE system, receive loans with 12% fewer covenants compared to control firms. This negative treatment effect is observed for both financial and nonfinancial covenants.

Overall, our findings suggest that when the secondary bond market becomes more transparent, borrowing firms can get loans with fewer restrictions. This evidence provides important implications for both academics and regulators, as bond market transparency is a policy variable determined by regulatory policies.

Furthermore, our evidence of bond market-level transparency shaping debt contract design suggests a mutual reliance between private and public debt market participants, whereas prior academic research has primarily focused on the role of banks as delegated monitors in facilitating public debt contracting and equity share issuance.

Kyung and Chy’s study, “The effect of bond market transparency on bank loan contracting,” was published by the Journal of Accounting and Economics.