Corporate bond covenants and social responsibility investment

Guifeng Shi and Jianfei Sun*

                                                            * G. Shi, shigfeng@sjtu.edu.cn, Antai College of Economics and Management, Shanghai Jiao Tong University, 535 Fahua Zhen Rd., Shanghai 200052, China; J. Sun, sunjianfei@sjtu.edu.cn, corresponding author, Antai College of Economics and Management, Shanghai Jiao Tong University, 535 Fahua Zhen Rd., Shanghai 200052, China. We acknowledge funding from the National Nature Science Foundation of China (NSFC-71002036) and Shanghai Pujiang Program (13PJC078). All errors are our own. 

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Corporate bond covenants and social responsibility investment

Abstract

This study investigates whether corporate social responsibility (CSR) investment is an effective channel to reduce the number of bond covenants such that CSR enables a firm to mitigate the information asymmetry associated with debt. We find that a high CSR score has a significant negative association with the number of bond covenants. Moreover, our results are more pronounced for firms with a high bid-ask spread and low analyst coverage, firms that issue low-rating bonds, and firms that experience economic shocks and locate in rural areas. Our analysis highlights the effect of the good stakeholder relationship on the debt contract. Keywords: Bond covenants; Corporate social responsibility investment; Information asymmetry JEL Classifications: G32; G24; G12

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1. Introduction

Covenants are a ubiquitous and persistent phenomenon in bond contracts. To explain the wide

existence of bond covenants, prior studies typically employ the agency theory framework of

bondholder-shareholder conflicts of interest, expressed in Jensen and Meckling (1976) and Smith

and Warner (1979). One solution for bondholders is to write covenants into the bond contract ex

ante to constrain shareholders or managers from taking actions that are detrimental to the

bondholders ex post. The classic view of bond covenants suggests that observed bond covenants

play a pivotal role in reducing the costs associated with the conflict of interest between firm and

bondholders. In their seminal paper on financial contracting, Smith and Warner (1979) develop

the costly contracting hypothesis,1 which argues that when contracting is costly, bond covenants

provide a tradeoff between a reduction in information asymmetry and agency costs associated

with bonds and the costs of negotiating and enforcing covenants, as well as the potential loss of

financial flexibility that covenants entail. This suggests that there is an optimal set of covenants

that maximizes the value of the firm. Recent literature has investigated possible channels to

balance the aforementioned costs and to find ways to reduce contract restriction of debt; these

include legal institutions (Demirguc-Kunt and Maksimovic, 1998; Qian and Strahan, 2007),

political institutions (Qi, Roth, and Wald, 2010), corporate governance mechanisms (Sengupta,

1998; Bhojraj and Sengupta, 2003; Li, Tuna, and Vasvari, 2011) and others.

Our research question is whether corporate social responsibility (CSR) investment serves as an

effective channel to reduce the number of bond covenants, enabling CSR firms to mitigate

information asymmetry and agency problems associated with debt without potential loss of

                                                            1 The costly contracting hypothesis tries to explain how firms reduce the costs of bondholder-stockholder conflict and helps to account for the variation in debt contracts across firms. 

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financial flexibility. That is, does the good relationship between firm and stakeholders affect the

debt contract between firms and bondholders? In this paper we focus on covenants in the debt

contract of corporate bonds. Corporate bonds typically have longer maturities and a larger

offering amount than bank loans, and they use different categories of covenants. The reason that

we focus on bond market rather than loan market is the following. Bond market and loan market

differ substantially in terms of private information availability and monitoring efficiency

(Diamond, 1984; Fama, 1985; Rajan, 1992; Bhattacharya and Chiesa, 1995). Bond market shows

the less informational efficiency than loan market before default dates (Altman, Gande and

Saunders, 2010), and the bondholders might require more voluntary information disclosure since

the bond market experiences more severe information asymmetry problem than loan market.

Thus, CSR voluntary disclosure may be more valuable and risk relevant to bondholders than to

banks (Ge and Liu, 2012). Moreover, bond covenants are expected to have more of a binding

effect than debt covenants in bank loan agreements since there is a rational expectation of a

lower probability of renegotiation of the bond contract (Mansi, Qi, and Wald, 2012). We

construct a CSR score to represent corporate social responsibility investment at the level of the

individual firms using data from the KLD Research & Analytics database (hereafter KLD),

which is the most comprehensive database available for rating corporate social responsibility.

Ultimately, we collect from the Fixed Income Securities Database (FISD) a sample of 2,135

bond issues from 698 US public firms in the years 1991-2010.

Our key finding is that firms with a high CSR score have a significantly negative correlation

with the number of bond covenants in four categories: investment covenants, dividend covenants,

subsequent financing covenants, and event covenants.2 Our results are both statistically and

                                                            2 Chava, Kumar, and Warga (2010) also study merger covenants. Our paper classifies them as a part of investment covenants. Results would not change either way.  

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economically significant. CSR investment enhances a firm’s reputation, serves as a signal of a

firm’s quality, and reduces information asymmetry as well as a firm’s litigation risk and financial

risk. Thus, CSR can effectively substitute for bond covenants, as a good relationship between

firm and stakeholders can positively affect the debt contract between firms and bondholders.

One alternative explanation for the results is that CSR influences bond covenants through its

corporate governance role. However, the results from durable industry and external and internal

monitoring are inconsistent with the notion that the effects of CSR scores are driven by

stakeholder monitoring, corporate governance, and manager entrenchment. Nor can our results

be explained by the good performance hypothesis. While there are two types of risks that

creditors are concerned about when designing debt contracts (Bhojraj and Sengupta, 2003):

agency risk and information asymmetry risk. Our results focus more on the latter. We consider

the endogeneity problem resulting from omitted variables, and our main results hold when we

control for a large number of geographic, demographic, and firm-specific variables. We further

address the endogeneity problem more generally by identifying instrumental variables in Two-

Stage Least Squares (2SLS) specifications. The results continue to hold when subject to a variety

of additional robustness checks. We find, too, that the results are more pronounced for firms with

a high bid-ask spread of traded bonds and low analyst coverage, firms that issue low-rating

bonds, firms in periods of economic shock and firms in rural areas – all of which are consistent

with the argument that CSR, as a signal of a firm’s reputation and credibility, mitigates the

information asymmetry between issuing-bond firms and bondholders.

This article contributes to three strands of literature. First, it contributes to a growing empirical

literature on financial contracting (Roberts and Sufi, 2009) by suggesting a viable alternative to

the use of covenants. Existing literature on financial contracting uses agency as an explanatory

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framework (e.g., Chava and Roberts, 2008; Nini, Smith, and Sufi, 2009; Chava, Kumar, and

Warga, 2010). Many studies show that covenant use is determined by the tradeoff between

reduced financing costs or enhanced borrowing capability on the one hand and loss of operation

flexibility or a firm’s investment opportunity set on the other (e.g., Malitz, 1986; Begley and

Feltham, 1999; Nash, Netter, and Poulsen, 2003; Bradley and Roberts, 2004; Billett, King, and

Mauer, 2007; Qi and Wald, 2008; Chava and Roberts, 2008; and Roberts and Sufi, 2009; Chava,

Kumar, and Warga, 2010). We find that CSR is a creditable signal of reputation, one that

mitigates information asymmetry and substitutes for the role of covenants, and as a result, higher

CSR firms can enjoy a lower cost of debt contract without sacrificing financial flexibility and

investment opportunity.

Second, this article contributes to the literature that investigates channels for mitigating

agency cost and information asymmetry and for reducing the cost of debt contracts (Demirguc-

Kunt and Maksimovic, 1998; Sengupta, 1998; Qian and Strahan, 2007; Qi, Roth, and Wald, 2010;

Chava, Kumar, and Warga, 2010; Li, Tuna, and Vasvari, 2011). Qi, Roth, and Wald (2010)

document that the cost to firms of debt financing tends to be lower when there are stronger

political institutions. Chava, Kumar, and Warga (2010) find that manager entrenchment

aggravates investment risk but ameliorates risk from shareholder opportunism. Thus, they find

that manager entrenchment can complement or substitute for bond covenants. Li, Tuna, and

Vasvari (2011) examine the effects of multiple corporate governance mechanisms on the

restrictiveness of debt contracts. They document a substitutive relation between a borrower’s

corporate governance and restrictive covenants imposed by lenders. This paper finds CSR to be

relevant in that it is another important and effective channel to reduce the information asymmetry

risk between borrowers and bondholders, especially for firms with high bid-ask spread, low

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analyst coverage, and low-rating bonds, and firms in the time of economic shock and firms

located in rural areas, which all experience greater information asymmetry. CSR might be a less

costly channel to mitigate this risk than bond covenants, which is consistent with the contracting

efficiency theory (Smith and Warner, 1979; Rajan and Winton, 1995; Chava, Kumar, and Warga,

2010).3

Third, this article complements the growing literature about the role of CSR in capital markets.

Enhancing reputation and image by investing in stakeholders results in low debt ratios (Bae,

Kang, and Wang, 2011), low financing cost (Dhaliwal, Li, Tsang, and Yang, 2011; Ghoul,

Guedhami, Kwok, and Mishra, 2011; Goss and Roberts, 2011; Oikonomou, Brooks, and Pavelin,

2011), more favorable analyst recommendations (Ioannou and Serafeim, 2010) and lower analyst

forecast error (Dhaliwal, Radhakrishnan, Tsang, and Yang, 2012) as well as higher shareholder

returns (Edmans, 2011) and less information asymmetry (Hung, Shi and Wang,2013). We

emphasize on the important role of CSR in mitigating the information asymmetry of firms’

costly financial contracts

The rest of this article proceeds as follows: Section 2 reviews the previous literature and

develops the hypotheses. Section 3 describes the sample and data sources. Section 4 presents the

main empirical setting and results along with some additional empirical analyses. Section 5

concludes.

2. Literature review and hypothesis development

Covenants are written into debt contracts to reduce agency cost and information asymmetry

problems between shareholders or manager and bondholders, thereby conveying private                                                             3 The likelihood of covenant inclusion is higher when (1) shareholders or managerial moral hazard present a higher agency risk for bondholders, and (2) alternative mechanisms are costlier channels for reducing this risk (Chava, Kumar, and Warga, 2010). 

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information, lowering financing costs, and increasing the availability of debt and overall firm

value (Smith and Warner, 1979; Dichev and Skinner, 2002; Bradley and Roberts, 2004; Drucker

and Puri, 2009; Demiroglu and James, 2010b). Opportunistic shareholders and managers can

hurt bondholder interests through many kinds of financial policies (Chava, Kumar, and Warga,

2010) such as consolidation or mergers, large dividend payouts, subsidiary borrowings and

guarantees, sales of assets, etc. Therefore, bondholders use covenants to restrict consolidation or

merger, investment policy, payout policy, and subsequent financing policy. Bhojraj and

Sengupta (2003) classify two types of risks that creditors are concerned about when designing

debt contracts. The first type is “agency risk,” that is, the risk that managers or shareholders (but

especially managers), acting in self-interest, may not act in the best interests of their firms’

creditors; another possible agency risk is that the manager is incompetent. Agency risk also

might involve managers shirking and expropriating creditors (Jensen and Meckling, 1976). The

second type is “information risk,” the risk that managers or shareholders possess adverse private

information about the probability of default which they do not disclose to creditors. Agency and

information-related problems also significantly limit loan selling in the secondary loan sales

market (Drucker and Puri, 2009). Governance mechanisms are intended to curb agency risk by

monitoring roles and to help reduce information risk by inducing firms to disclose information in

a timely manner (Bhojraj and Sengupta, 2003). Many bond covenants are also specifically

designed to mitigate agency conflicts and information risk (Drucker and Puri, 2009; Christensen

and Nikolaev, 2012).

The literature suggests that there are several channels for mitigating information asymmetry

and agency cost and reducing the cost of debt: legal institutions (Demirguc-Kunt and

Maksimovic, 1998; Qian and Strahan, 2007); political institutions (Qi, Roth, and Wald 2010);

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and corporate governance mechanisms (Sengupta, 1998; Bhojraj and Sengupta, 2003; Li, Tuna,

and Vasvari, 2011). We argue that CSR investment should be regarded as another important

channel. The literature investigating links between CSR and the cost of debt financing has been

growing recently. Cheng, Ioannou, and Serafeim (2013) find that firms with better CSR

performance face significantly lower capital constraints. Moreover, higher levels of stakeholder

engagement and transparency related to CSR performance play an important role in reducing

capital constraints. The results from Oikonomou, Brooks, and Pavelin (2011) indicate that higher

levels of corporate social performance can lead to improved credit quality, lower perceived credit

risk, and lower cost of corporate debt. Meanwhile, Goss and Roberts (2011) find a statistically

significant but economically modest relationship between corporate social responsibility and the

cost of debt financing, as measured in terms of reduced loan spreads for a large sample of US

firms from 1991 to 2006. CSR is a second-order determinant of yield spreads, and the modest

premium offers little incentive for firms to improve their CSR performance (Goss and Roberts,

2011). Ye and Zhang (2011) examine a possible non-linear relationship between CSR and the

cost of debt. Improved CSR appears to reduce the cost of debt financing when firms’ CSR

investment is at a lower than an optimal level, but increases the cost of debt financing when the

CSR investment exceeds the optimal level (Ye and Zhang, 2011). Ge and Liu (2012) find that

CSR disclosure is associated with lower yield spreads of new corporate bond issues in the U.S.

primary bond market. Some studies single out one dimension of the total CSR score to examine

the possible relation between CSR investment and the cost of debt financing. Bauer and Hann

(2010), for example, focus on environmental concerns and find these concerns to be associated

with a higher cost of debt financing and lower credit ratings; proactive environmental practices

are associated with a lower cost of debt. Fang, Francis, Hasan, and Wang (2012) find that

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borrowing firms with active alliance involvement experience lower cost of bank loans. Chen,

Kacperczyk, and Ortiz-Molina (2012) report that unionized firms face lower costs of debt than

non-unionized firms, because unions mitigate the tendency for shareholders to expropriate

bondholders.

And yet, few studies have examined whether CSR investment affects potential agency

conflicts and information asymmetry between firms and bondholders, and whether it

consequently affects bond covenants. According to the contracting efficiency theory for bond

covenants (Smith and Warner, 1979; Rajan and Winton, 1995), bond covenant is one channel by

which the behavior of shareholders is constrained (Smith and Warner, 1979). And we argue that

CSR might represent a less costly mechanism or provides more benefits to bondholders seeking

to mitigate potential conflict between issuing-bond firms and bondholders. Therefore, we

hypothesize that higher CSR investment or superior CSR performance results in fewer bond

covenants and restrictions of debt contracts. The arguments involve: (i) screening and signaling

effect from issuer’s view, and (ii) risk-reducing effect from investors’ view.

2.1 Screening and signaling effect from issuer’s views

Basically, superior CSR performance stands for the firm’s commitment to and engagement

with stakeholders on the basis of ethical solutions (Jones, 1995; Andriof and Waddock, 2002),

thus gaining the firm a reputation in financing markets (Cheng, Ioannou, and Serafeim, 2013).

Jones (1995) argues that contracting on the basis of mutual trust and cooperation – i.e.,

contracting based on ethical solutions – is more efficient than designing mechanisms to curb

opportunism. Furthermore, superior CSR performance is associated with better stakeholder

engagement, reducing the likelihood of short-term opportunistic behavior (Benabou and Tirole,

2010; Eccles, Ioannou, and Serafeim, 2012) and overall contracting costs (Jones, 1995).

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Additional studies examine the effect of firm reputation on financing (Eaton and Gersovitz 1981,

John and Nachman, 1985; Grossman and Van Huyck, 1988; Diamond, 1991; Gomes, 2000;

Siegel, 2005; Demiroglu and James, 2010a). For example, Demiroglu and James (2010a) find

that private equity sponsors in LBO transactions might benefit from an enhanced reputation in

terms of looser covenant settings. Their results indicate that reputation serves as a substitute for

bank monitoring and control and reduces information asymmetry costs. The reputation that is

created by CSR investment signals firm quality and helps reduce information asymmetry

between the firm and the bond market. Therefore, in equilibrium, firms with good reputations

also receive higher credit ratings and issue bonds at higher prices (John and Nachman, 1985).

Collateral is regarded as a potential signal of borrower quality (see, for example, Jimenez, Salas,

and Saurina (2006)), and covenants should be regarded likewise. The empirical findings of

Demiroglu and James (2010b) indicate that the selection of tight financial covenants conveys

positive private information concerning future prospects, consistent with the signaling hypothesis

of covenants. Covenants are “screening devices” and thereby reflect positive information or

signal that the firm is willing to stay in an observably good region (Dichev and Skinner, 2002;

Drucker and Puri, 2009). We argue that CSR, too, can take on this screening and signaling role

as bond covenants.

2.2 Risk-reducing effect from investors’ view

Information is important to investors. When facing uncertainties, investors would make their

portfolio decisions based on securities with more information and less risk. As Merton (1987)

shows, since each investor knows only about a (same or different) subset of the available

securities, she would choose a security in constructing her portfolio only if she knows about the

security. CSR reports reveal information about the firms. If investors also perceive stocks with

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higher CSR as those with more information, then we would expect a negative relationship

between CSR and firm risk.

Firms with better CSR performance are more likely to disclose their CSR activities to the

market (Dhaliwal, Li, Tsang, and Yang, 2011). This can signal their long-term focus and

differentiate themselves among peers (Spence, 1973; Benabou and Tirole, 2010), and, as a result,

reduce informational asymmetry. When information is more asymmetric between firms and non-

informed (bond) investors, non-informed (bond) investors are more likely to require a higher

bond price or more covenant protection. Previous research has shown that the use of covenants is

positively correlated with a firm’s informational asymmetry (Chava, Kumar and Warga, 2010).

On the contrary, increased information disclosure can reduce informational asymmetry between

the firm and investors (e.g. Botosan, 1997; El Ghoul, Guedhami, Kwok, and Mishra, 2011) and

leads to lower capital constraints (Hubbard, 1998), a lower cost of capital (Ng and Rezaee, 2012),

and improved market liquidity (Lang, Lins, and Maffett, 2012).

Literature has documented evidence that socially responsible firms are more likely to be less

volatile and less risky firms (Spicer, 1978; Orlitzky and Benjamin, 2001). These risks include

firm systematic risk, litigation risk, and financial distress risk.

Spicer (1978) finds that firm social performance measured by pollution control can reduce

firms’ systematic risk. Orlitsky and Benjamin (2001) document a negative relation between a

firm’s CSR and its financial risk. They further find that CSR is negatively correlated with a

firm’s market risk. Albequerque, Durnev and Koskinen (2012) find that when a firm increases

CSR spending, its risk is lowered accordingly, although the marginal benefit has decreased over

time. Using a UK panel data from 1994 to 2006, Salama, Anderson, and Toms (2011) and

Oikonomou, Brooks, and Pavelin (2012) also find a negative yet marginally significant

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relationship between CSR and systematic firm risk. They examined CSR from the perspectives

of community and environment.

CSR can also reduce litigation risk. For instance, new or potential governmental regulations

might relate to product safety, environmental preservation, and other aspects of social

responsibility. Socially responsible investment may help a firm reduce such risks and costs.

Hong and Kacperczyk (2009) find socially irresponsible firms, or so called “sin” firms, face

higher litigation risks, such as from lawsuits for environmental pollution, unsafe products,

employee benefits, and so forth., that will likely result in negative cash flows in the future.

Waddock and Graves (1997) show that firms with poor corporate social performance may

choose to sell an unsafe product for certain reasons. This will increase the chance of future

lawsuits against the firm and thus bring potential fines or civil penalties to the firm. Feldman,

Soyka, and Ameer (1997) find that firms adopting a more environmentally pro-active posture

experience a significant reduction in perceived riskiness to investors, and thus bring more

investment values to investors. Kim, Park, and Wier (2012) find that firms with high CSR are

less likely to manage earnings through both discretionary accruals and real operating activities,

and less likely to be the subject of SEC investigations as evidenced by Accounting and Auditing

Enforcement Releases against top executives.

CSR can reduce financial distress risk as well. A high-CSR firm is less likely to experience

financial distress (Goss, 2009) and has a lower risk of bankruptcy (Jiao and Shi, 2012). Cheng,

Ioannou, and Serafeim (2013) find that firms with better CSR performance face significantly

lower capital constraints. They further show that better stakeholder engagement and transparency

around CSR performance are important in reducing capital constraints. Sharman and Fernando

(2008) find that higher leverage firms with more environmental controls are able to support a

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higher debt level because of a reduction in risk. Mansi, Qi, and Wald (2012) argue that bond

covenants can effectively restrict management thus also leading to a reduction in bankruptcy risk.

They find that actual (as opposed to predicted) covenant use is associated with a lower

probability of bankruptcy and longer firm survival. This evidence is consistent with the notion

that the use of covenants reduces bankruptcy risk. CSR can play the same role (Jiao and Shi,

2012) and therefore substitute for covenants.

2.3 A simple model

Consider the following simple model.4 Assume that a large shareholder (L) holds a fraction

5.0 of the firm. With probability of I, L can adopt a certain amount, s, of CSR investment to

increase firm value from q to q+Z(s), where Z ~ F(Z) with the support of (0, Zmax ] and is

increasing in s. Finding an improvement of value Z, L can make a tender offer of 5.0 to gain

control over the firm. Suppose that L also incurs a borrowing cost of C to improve the firm value

by Z.5 C represents the cost of borrowing that L has to bear in order to improve the firm value.

For example, if bond covenants between L and bondholders is higher, then C is higher. I further

assume that the cost C is a function of . is continuous and represents the restrictions that

bondholders impose on firms when making decisions of lending. We also assume )(C is

increasing in .6

L will make a tender offer if he can buy 5.0 of the shares from the small shareholders for

any bid q , with satisfying the following

                                                            4 This is a revised Shleifer and Vishny (1986) model. Other models (e.g., the principal-agent model) can reach the same conclusion (e.g., Baker and Jorgensen, 2002). 5 Shareholders with sufficient fund may not need to raise fund from bondholders, but since this would not be the focus of this paper and thus is not considered.  6 Introducing delta coefficient in the model is only meant to simplify the process and illustrate how covenants matters. There are other ways that can better handle the issue, but that can lead to much longer mathematical description. 

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0)5.0(5.0 CZ .

Given L’s strategy, the small shareholders’ best forecast of Z is given by

]0)5.0(5.0[ CZZE .

Therefore, the tendering is the best strategy if and only if

0]0)5.0(5.0[ CZZE .

L needs to maximize her own share of the firm wealth,

]}0,)()5.0(5.0{max[),(* CZEIIB .

The firm value then is given by

)]([)]}([1{)(),( * CC ZZZEZFIqqV

.

Under these conditions, it is easy to show that in equilibrium an increase in s, the amount of

CSR investment, results in a fall in , by the comparative statics.

Based on all the above discussions in Section 2, we see that there may exist a substitutive

relationship between CSR activities disclosure and covenants. Therefore, we propose the

following hypothesis:

Hypothesis: The number of a firm’s bond covenants is negatively associated with a firm’s

CSR investment.

3. Data

We start building our sample by obtaining CSR data from KLD Research & Analytics.7 The

KLD database is widely used in empirical studies (Johnson and Greening, 1999; Coombs and

                                                            7 KLD is an independent rating agency specializing in assessing corporate social performance for a large sample of

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Gilley, 2005; Chatterji, Levine, and Toffel, 2009; Benson and Davidson, 2010; Jiao, 2010; Bae,

Kang, and Wang, 2011; Kim, Park, and Wier, 2012). Therefore, the database is a well-

established measure of both stakeholder management and corporate social responsibility

investment. Firms are rated with a strength score and a concern score in seven major categories:

community, diversity, corporate governance, employee relations, human rights,8 environment,

and product.9 In defining our CSR proxy, we follow the prior literature to use all the seven major

categories.10 We then construct a CSR score, measured as total strengths (positive ratings) minus

total concerns (negative ratings) in all KLD’s seven social rating categories.

It is worth emphasizing that the KLD database is by far the most comprehensive and unbiased

database available for ratings that take firms’ stakeholders into account. Edmans (2011) and Bae,

Kang, and Wang (2011) use Fortune’s ‘‘100 Best Companies to Work For’’ as a proxy or

alternative measure of a firm’s treatment of employees. At the same time, the Business Ethics

“100 Best Corporate Citizens” (hereafter 100BCC) ratings serve as an alternative proxy for CSR.

When we rank firms in the KLD and 100BCC databases based on the scores they receive in each,

we find the two rankings to be almost identical. Furthermore, the ranking standards are very

similar across the two datasets.11 The biggest difference is that the KLD database covers a much

larger sample of firms.

                                                                                                                                                                                                publicly traded companies in the US since 1991. It collects information from a variety of sources including company filings and direct communications with the company, governments and other organizations, as well as media, and it rates firms using a proprietary framework of positive and negative indicators. 8 The category of human rights was added to the KLD database in 1995. 9 There are five additional dimensions including alcohol, gambling, military contracting, nuclear power, and tobacco. We do not consider these dimensions in constructing CSR score since they are exclusionary screen categories. 10 We do not exclude corporate governance that comprises of transparency and accounting related strength and concerns, as well as compensation and governance structure related components, although it reflects the conflicts of interest between managers and shareholders. However, our results remain unchanged if we exclude corporate governance. 11 The 100BCC uses 3-year KLD averages of standardized values according to the list in 2001. From 2002 to 2004, 100BCC used community, minorities and women, employees, environment, non-US stakeholders, customers. From 2005 to 2007, 100BCC used the same categories as KLD. 

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Next, we match KLD data with bond covenant data from the Fixed Income Securities

Database (FISD).12 Furthermore, the bond must be a corporate debenture with issuance, offering

date, and covenant information available in FISD. In addition, we exclude bonds with missing

covenant information, bonds issued by foreign firms and financial firms, and bonds denominated

in foreign currency.13 For the firm that has multiple bond issuances on the same date, we

compute a simple average of all bond characteristics. Finally, we make available data on other

bond-specific and firm-specific variables used in regression analyses. This provides us with an

initial sample of 2,135 bond issues from 698 firms during the period 1991-2010.

The number of covenants is important. Therefore, following Bradley and Roberts (2004) and

Chava, Kamar, and Warga (2010), we assume that more covenants place greater restrictions on

operation of the issuing firm that are detrimental to the bondholders. We simply treat the number

of covenants included in the debt agreement as the restrictions or strictness, similar to the

covenant index constructed by Bradley and Roberts (2004) and Murfin (2012).14 Following

Smith and Warner (1979) and Chava, Kamar, and Warga (2010), we place bond covenants into

four categories: investment covenants,15 dividend covenants,16 subsequent financing covenants,17

and event covenants.18 In addition, we calculate the total number of covenants. In the case of

subsidiary and parent companies, the covenants of both are considered.

                                                            12 FISD provides detailed information on debt securities issued by corporations, US agencies, US Treasury, and foreign issuers. 13 We exclude firms which issue bond without any convents. But our main results are unchanged when we include these firms. 14 Bradley and Roberts (2006) explain in details the reason why they examine an aggregate measure of covenant structure for loan contract. 15 Investment covenants include consolidation or mergers restrictions, indirect investment restrictions, bonds being secured, stock sale restrictions, or direct investment restrictions. 16 Dividend covenants stipulate whether the bond’s indenture restricts dividends and other payments. 17 Subsequent financing covenants include debt priority restrictions, stock issuance restrictions, subordinate debt restrictions, restrictions on sale and lease obligations. 18 Event covenants include default-related event covenants and stipulate whether the indenture contains a change in control poison put. 

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4. Empirical results

4.1 Regression specification

To capture the relation between bond covenants and CSR, we estimate the following model:

titi

n

mjjti

m

jjtiti sticscharacterifirmsticscharacteribondCSRCovenantsof ,,

1,

2,10,#

All else being equal, we expect 1 , the key coefficient of interest, to be negative. Following

Chava, Kumar, and Warga (2010), the regression is based on bond-year samples.19 

In the above model, we also control for various characteristics of bond issues: maturity, loan

size, bond rating,20 an indicator variable for bonds that are privately placed, and whether they are

callable or putable. As Klock, Mansi, and Maxwell (2005) do when they regress the credit

ratings on their governance index, we regress the bond rating on the CSR variable and label the

error term from this regression as our primary measure of credit ratings in the multivariate

analysis.21 We also control for a series of firm-specific variables that are likely to be associated

with debt contract terms: size, ROA, market-to-book ratio, tangible ratio, leverage. We use the

log of assets as the proxy for size. We measure ROA as net income before extraordinary items

divided by total assets. The quality of a firm’s investment opportunities and firm size determine

the types of covenants included. Following the literature, we use a logarithm of the market-to-

book ratio as a proxy for growth options. Since a high proportion of tangible assets tends to

improve borrowing ability, we use the ratio of tangible-to-total assets (gross PPE divided by total

                                                            19 The results are similar when we run a regression using firm-years. 20 The bond rating is the average credit rating of the bond provided by three rating agencies: S&P, Moody’s, and Fitch. If the rating of issue is missing, it is replaced by the average credit rating of the issuer or is replaced by the S&P long-term issuer rating from Compustat. We convert the credit rating into the S&P numerical scale as follows: 21-AAA, 20-AA+, 19-AA, 18-AA-, 17-A+, 16-A, 15-A-, 14-BBB+, 13-BBB, 12-BBB-, 11-BB+, 10-BB, 9-BB-, 8-B+, 7-B, 6-B-, 5-CCC+, 4-CCC, 3-CC, 2-C, and 1-D&SD. 21 Oikonomou, Brooks, and Pavelin (2011) find CSR scores lead to improved credit quality. Therefore, we regress the credit ratings on CSR scores and generate the error term that incorporates the credit rating information without the impact of CSR. They also discuss a case that supports the effects of CSR on credit ratings. The oil spill incident in the Gulf of Mexico led to downgrading of the BP bond from AA to BBB by the rating agency Fitch. 

18  

assets). We measure leverage as the total debt divided by total assets. ROA, tangible ratio and

leverage are winsorized at the top and bottom 1 percent of their distributions. Finally, we

address possible industry effect and year effect through the controls of the Fama-French 48

industry dummies22 23 and year dummies.

4.2 Univariate analysis

Table 1 reports descriptive statistics (see Appendix A for variable definitions). The average bond

has a total of 6.85 covenants. In our samples, covenants tended to relate to investment,

subsequent financing and event restrictions, and on average each bond entailed more than one

covenant covering each of these concerns. Smith and Warner (1979) argue that investment,

dividend, and financing policy are likely to be determined simultaneously, and that covenants

which restrict dividend and financing policy also restrict investment policy. Thus, a bond

contract might not specifically include every kind of covenant.

According to Chava, Kamar, and Warga (2010), the vast majority of bonds are senior with a

median offering amount of $250 million and a median maturity of 10 years.24 In our full samples,

the bond offering amount, on average, is $369.56 million and the average maturity is 12.19 years.

The average bond rating is 12.99 with 21 being the maximum rating ratio. 4 percent of our

samples are bonds that are privately placed. Furthermore, 75 percent are callable and 2 percent

are putable. Firms in our sample have assets averaging $15,425 million, an average ROA of 0.05,

and an average market-to-book ratio of 3.64. The tangible ratio and leverage ratio are 0.71 and

0.33, respectively.

                                                            22 Our results do not change when we use two-digit SIC industry classification. 23 We use industry instead of firm fixed effects because of insufficient within-variation over time in CSR scores and including firm fixed effects would force identification of the CSR-related coefficients from these changes. This point is in a similar vein to one made for the GIM index by Gompers, Ishii, and Metrick (2003) and Giroud and Mueller (2011).  24 In our sample, 89.37 percent of bonds are senior (not reported); in Chava, Kamar, and Warga (2010), the portion is 82.7 percent. 

19  

[Insert Table 1]

If CSR scores have different impacts on bond covenants, we would expect the number of bond

covenants to vary across firms with high CSR scores and low CSR scores. Thus, using univariate

statistics, we examine the relationship between CSR score and number of bond covenants

alongside some control variables.

We define firms with above (below) the median CSR scores in the sample as high (low) CSR

scores. Table 2 presents the time-series means for the number of bond covenants and firm-

specific variables and measures the differences between firms with high and low CSR scores

(high CSR - low CSR). The results show that for firms with high CSR scores, the numbers of

covenants for all four categories are less than those for firms with low CSR scores, with the t-

statistics on the difference being all 1 percent statistically significant. This suggests that firms

with high CSR scores tend to have bonds with fewer covenants. Indeed, it indicates that CSR

investment takes the place of bond covenants. In addition, the firms with high CSR scores tend to

be bigger and more profitable, with higher market-to-book ratio, and lower leverage.

[Insert Table 2]

4.3 Multivariate regression analysis

4.3.1 The main results

In this section, we examine whether the number of bond covenants is negatively associated with

CSR investment. The panel A of Table 3 presents the results of five multivariate tests that

investigate the association between the number of bond covenants and CSR scores. Each of our

dependent variables represents an attempt to capture either a total or one category of bond

covenants as defined by Smith and Warner (1979). Taking into account that the residuals can be

correlated across firms and/or over time, for all multivariate analyses we report test statistics and

20  

significance levels based on the standard errors double-clustered by firm and year (Peterson,

2009).

What we find is a negative relation between CSR score and the numbers of investment

covenants, dividend covenants, subsequent financing covenants and event covenants, indicating

that CSR firms issue bonds with fewer restrictions. Not surprisingly, CSR score has a

significantly negative association with the total number of bond covenants. These results are

consistent with the costly contracting hypothesis, indicating that firms try to reduce the costs of

the conflict between bondholders and stockholders or managers through CSR investment.

Furthermore, CSR might be a less costly channel of mitigating this conflict than bond covenants,

according to the contracting efficiency framework (Smith and Warner, 1979; Rajan and Winton,

1995; Chava, Kumar, and Warga, 2010). In addition, we compare the coefficients of CSR within

the regressions of four categories of covenants. The untabulated results (using suest test) indicate

that CSR functions more often as a substitute for financing covenants than for investment

covenants, dividend covenants, and event covenants, suggesting that the effect of CSR is greater

with regard to financing restrictions. This is also consistent with Smith and Warner (1979).

In Panel B, we add more bond-specific and firm-specific omitted control variables to reinforce

the results of Panel A of Table 3.

In Column 1 of Panel B, we check whether our results are robust when we control for the cost

of debt. Following Shi (2003), Jiang (2008), and Wang and Zhang (2009), we use yield spread as

a proxy for cost of debt. Yield spread is defined as the difference between the issue's offering

yield to maturity and the yield on U.S. Treasury bond of comparable maturity on the issuance

date (measured in basis points).

21  

Corporate governance and manager entrenchment can also influence the usefulness of bond

covenants (Chava, Kumar, and Warga, 2010). In Column 2 of Panel B, we use the presence of

block holders (where a block is defined as 5% or more ownership) and the percentage of shares

held by institutional investors for one quarter prior to the bond issuing date,25 as proxies for

external monitoring. In column 3 of Panel B we add GIM index from Gompers, Ishii and Metrick

(2003)26 as a proxy for internal monitoring.

The anecdotal evidence suggests that only large firms with enough resources and financial

slack are likely to undertake CSR investment, and less constrained firms spend more on CSR

(Hong, Kubikz, and Scheinkman, 2012). Accordingly, financial slack may be an omitted variable

since it enhances CSR investment and affects bond contracts. Following Baker, Stein, and

Wurgler (2003) and Hong, Kubikz, and Scheinkman (2012), in Column 4 we use the KZ score as

an initial measure of financial slack, constructing a KZ score for each firm-year such that firms

with lower values are identified with more financial slack.27 In Column 5 of Panel B, we control

all five omitted variables.

For all the above regressions in Panel B of Table 3, we can see that CSR is significantly

negatively associated with the number of covenants. Our main results hold.

[Insert Table 3]

                                                            25 We compute the total institutional ownership as of the quarter prior to bond issuance. The institutional investors include socially responsible (SR) mutual funds, so we do not treat separately the shareholding of SR mutual funds as an omitted variable. The data is from Thomson. 26 The score (gindex) is obtained from the IRRC database and is available for the years 1990, 1993, 1995, 1998, 2000, 2002, 2004, and 2006 during the sample period. For intermediate years, we always use the gindex from the latest available year. 27 Our method of computing KZ scores is identical to that used by Baker, Stein, and Wurgler (2003) and Hong, Kubikz, and Scheinkman (2012); we construct the KZ Score for each firm-year as linear combinations using five variables (cash flow, cash dividend, cash balances, book leverage and Tobin’s Q). For brevity’s sake, we omit the detailed description of the construction of KZ scores. We winsorize the five components of the index at 1 percent. Cash holding is a critical indicator for CSR investing, and is included in the KZ score. When we treat cash holding as a separate control variable, the results are similar to those for KZ scores.  

22  

Furthermore, we use the Fama-MacBeth method to address the time-series clustering of

independent variables stemming from the limited changes in a firm’s CSR scores over time.

Fama-MacBeth regressions, along with Newey-West corrections, impose a structure on the fixed

effects such that they are a linear function of the CSR scores. Our untabulated analysis shows the

robustness of our results using this alternative estimation method.

4.3.2 Analysis based on individual KLD ratings categories

Although the main results suggest a negative association between the total CSR score and the

number of bond covenants, it is natural to ask whether some stakeholders are more important

than others in the eyes of the bondholders, or whether all individual KLD rating categories are

treated equally by bondholders. Prior studies (e.g., Turban and Greening 1997; Mattingly and

Berman 2006; Jiao, 2010; Kim, Park, and Wier, 2012) examine both aggregated and

disaggregated subscores from KLD data as a proxy for CSR. Therefore, we replace aggregated

CSR net scores with individual KLD ratings categories, that is, qualitative issue areas defined by

KLD as community (COM), governance (GOV), diversity (DIV), employee relations (EMP),

environment (ENV), human rights (HUM) and product (PRO), using a net score for each

category by subtracting total concerns from total strengths in order to investigate the relation

between these six CSR categories and number of bond covenants.

Taking the analysis further, we re-estimate the multiple regressions. Table 4 shows the results

for the total number of bond covenants as dependent variable.28 We find all the seven subscores

are negatively and significantly associated with the total number of bond covenants. Note that

the coefficients of DIV, EMP and ENV are 1 percent significant, those of COM and PRO are 5

percent significant, and those of GOV and HUM are 10 percent significant.

                                                            28 The results are similar when the dependent variables are the numbers of investment covenants, dividend covenants, subsequent financing covenants, and event covenants. 

23  

[Insert Table 4]

4.3.3 Analysis Based on Total Strengths and Concerns

In the main results, we compute CSR by subtracting KLD concerns from KLD strengths. One

concern is that KLD’s strengths and concerns lack convergent validity and hence should not be

used jointly. The empirical results of Mattingly and Berman (2006) indicate that “social

concerns” is not simply the converse of “social strengths” and vice versa. Furthermore,

aggregating social strengths and weaknesses might generate countervailing effects and hide some

important differences (Mattingly and Berman, 2006; Kim, Park, and Wier, 2012). For instance,

two firms might have the same aggregated CSR net score, one, but one firm has six strength

scores and five concern scores, and another has one strength score and zero concern score. The

two firms undoubtedly demonstrate different social behavior, but aggregating the strengths and

concerns kills the distinction (Chatterji, Levine, and Toffel, 2009). Therefore, to account for the

possibility that CSR strengths and weaknesses impact bond covenants differentially, we re-run

all the regressions in Table 3 using the strength and concern scores separately instead of using

the net scores.

Table 5 shows the results. In panel A, the coefficients of STR (KLD total strength scores) are

significant and negative for the regression of all four categories of bond covenants and total

covenants, indicating that the higher the KLD strength score, the less likely the firm-issued bond

will involve restrictions. Panel B of Table 5 shows the results for KLD total concerns. We find

positive and significant coefficients on CON (KLD total concern scores) for the regressions of

three categories of bond covenants (investment covenants, dividend covenants, and subsequent

financing covenants) and total covenants, while there is an insignificant association between

CON and events covenants. This evidence suggests that firms with higher CSR “concerns”

24  

scores are likely to insert more covenants restricting firm policy and risk-taking or opportunity

activities. In general, the results reported in Table 5 are consistent with those in Table 3, as the

strength scores are associated with fewer bond covenants and the concern scores are associated

with more bond covenants.

[Insert Table 5]

4.4 Endogeneity

In this section, we gauge the robustness of results by exploring the causality between the CSR

scores and bond covenants. It is possible that firms whose bond issues include fewer covenants

choose to invest more in CSR. One way of addressing this is to use the instrumental variable

method. Running a 2SLS regression, in particular, can remove estimation biases caused by this

causality – if the instruments are uncorrelated with the error terms and are sufficiently correlated

with the endogenous elements of the variable of interest. Thus, the 2SLS approach provides an

additional assurance against the risk that our results are driven by the causality.

When we run 2SLS regressions we use two instruments for the CSR scores. The first is a

dummy variable taking a value of one if a firm’s headquarter state is a blue state and zero

otherwise (a red or a other color state). Blue states and red states refer to those states of the

United States whose residents predominantly vote for the Democratic Party (blue) or Republican

Party (red) presidential candidates.29 Rubin (2008) finds that firms with high corporate social

responsibility ratings tend to be located in states with Democratic majorities, while firms with

low corporate social responsibility ratings tend to be located in states with Republican majorities.

Di Giuli and Kostovetsky (2011) also study the impact of political parties on CSR. They find that

                                                            29 We follow the definition from Wikipedia. Based on the results of the 2000, 2004, 2008, and 2012 presidential elections, the blue states are states carried by the Democrat in all four elections and the red states are states carried by the Republican in all four elections. For the other three cases, the dummy variable takes value of zero. For more detailed information on this, please check https://en.wikipedia.org/wiki/Red_states_and_blue_states.  

25  

firms with Democratic CEOs, founders, and directors are more socially responsible, as reflected

in higher KLD scores, than firms with Republican corporate stakeholders. In this paper,

following Rubin (2008), we use the above dummy variable as the first instrumental variable. 30

The second instrument is a lagged (5 years) CSR score. The reasoning is that firm-specific

capabilities captured by CSR metrics take several years to acquire and are more persistent than

indicators of financial performance. It is unlikely that CSR scores assigned to firms 5 years

before the initiation of the bond are going to be influential in setting bond contract terms.

There is a significant loss of data (final observations = 1120), since the firm must be in the

data set for 5 years before the lagged KLD observation can enter the regression. In the first stage

regression (not reported) of 2SLS, both coefficients of the instrumental variables are

significantly positive at 1% level. The corresponding F-statistics in the first stage regression is

higher than the approximate cutoff of 10 for weak instruments suggested by Stock and Yogo

(2005). Over-identification tests suggest that the instruments are valid (and for brevity are

omitted from reporting). The results of the second stage regression of 2SLS, tabulated in Table 6,

are similar to those reported in Table 3. We can see that when we control for the endogeneity, all

5 coefficients on predicted CSR are statistically significantly negative. In addition, Hausman

tests show that we cannot reject the null hypothesis and indicate that the endogeneity concern is

not substantiated.

[Insert Table 6]

Our next test to address the reverse causality problem is to use historical values of the CSR

scores, which are unlikely to be affected by current bond covenants. We use their first ever CSR

                                                            30 Specifically, the dummy variable is equal to 1 if the state is California, Washington, Michigan, Minnesota, Illinois, Wisconsin, Massachusetts, Delaware, New Jersey, Pennsylvania, Connecticut, Maine, Rhode Island, New York, Hawaii, Vermont, or Maryland. 

26  

values in the KLD database to replace the subsequent CSR scores.31 The outcome (untabulated)

shows our results to be robust to this alternative measure of CSR scores.

4.5 Additional robustness tests

We perform additional robustness tests, which for brevity are not reported here. First, prior

research suggests that the level of CSR may vary according to industry characteristics (Waddock

and Graves, 1997; McWilliams and Siegel, 2001). Therefore, in order to make our proxies for

CSR more comparable across industries, we replace the dependent variable with adjusted CSR

scores for the industry median in each year. The results corroborate our findings in Table 3,

suggesting that industry effects in CSR scores are not driving our results.

Second, the results also hold when we re-estimate our main regression after dropping all

observations for which the CSR score equals zero. This takes into account the possibility that

KLD might not evaluate scores for some firms and reports zeros instead, or that the firms have

zero CSR performance (Statman and Glushkov, 2009). The results in Table 3 are robust to this

test.

Third, we restrict our sample to three time periods. Beginning with 1991, KLD STATS

provides a table of data with a collection of approximately 650 companies comprised by the

Domini 400 Social Index and S&P 500 with one record for each company and columns

indicating membership of each index. Beginning in 2001, KLD expanded its coverage universe

to include all companies on the Russell 1000. In 2003, KLD added full coverage of the Russell

3000. Therefore, we re-estimate our main regression in three time periods: 1991-2000, 2001-

2010, and 2003-2010. The results are significantly similar to those in Table 3.

                                                            31 Considering the persistence of CSR scores from one year to the next, we delete the observations that appear in our sample within a three-year period. 

27  

Fourth, we delete firms on the S&P 500 index or the Domini 400 Social Index.32 Prior

research suggests that large firms invest more in social responsibility than smaller firms

(Waddock and Graves, 1997). Although we control for size in all of our main regressions, we

further mitigate this concern by examining the effect of CSR after excluding large and famous

firms, such as S&P 500 firms. At the same time, to mitigate the concern that firms with excellent

social responsibility dominate our results, we also delete the Domini 400 Social Index firms

(which excel in social and environmental categories including employee relations, product safety

standards, and environmental safety), published by KLD Research & Analytics. Our results in

Table 3 hold when we delete S&P 500 index firms and Domini 400 Social Index firms.

4.6 Channel of information asymmetry

We argue that CSR, as a signal of a firm’s reputation and credibility, mitigates the information

asymmetry between bondholders and insiders. We also have evidence to support the view that

the covenants-reducing effect of CSR is even more pronounced where there is little public

information, or where information asymmetry is heavy, or where reputation is very important.

First, if CSR helps to mitigate the information asymmetry related to a firm’s reputation, one

would expect that our results would be more pronounced for firms with a high bid-ask spread for

the traded bonds. After obtaining the gross bid-ask spread from the FISD database, we calculate

the average bid-ask spread on the issuer’s bond as traded on the market.33 We classify firms with

above (below) the median bid-ask spread in our sample as having high (low) information

asymmetry. Table 7 shows the association between CSR and bond covenants under conditions of

different degrees of bid-ask spread. For the first three columns of Table 7, the coefficients on the

interaction variables between the high bid-ask spread indicators and CSR scores are negative and                                                             32 Domini 400 Social Index is one of the first socially responsible investing indices. 33 FISD provides details on bond acquisitions and bond disposals (sales, redemptions) since 1995 by insurance companies. Some of our observations being lost, we end up with a sample of 1,456. 

28  

significant, suggesting that our results on total covenants, investment covenants, and dividend

covenants in Table 3 are more pronounced for firms with high bid-ask spread of traded bonds

and high information asymmetry between firms and bondholders.

[Insert Table 7]

Second, if CSR helps to mitigate the information asymmetry related to a firm’s reputation, one

would expect that our results would be more pronounced for firms with low analyst coverage.

Greater analyst coverage conveys more information to investors and reduces information

asymmetry (Brennan and Subrahmanyam, 1995; Hong, Lim, and Stein, 2000). Since firms

followed by a small number of analysts do not benefit from these information effects, CSR

activities may be more important for these firms. We analyze the information effect by

comparing our results for higher analyst coverage firms with lower analyst coverage firms based

on a median of analyst coverage provided by Thompson Institutional Brokers Earnings Services

(I/B/E/S). We define firms with below (above) median analyst coverage in our sample as having

high (low) information asymmetry. Table 8 presents the results of our analysis of the influence of

analyst coverage. The coefficients on the interaction variables between low analyst coverage

indicators and CSR scores are significantly negative. Therefore, our results on total covenants,

investment covenants, and subsequent financing covenants in Table 3 are more pronounced for

firms with low analyst coverage and high information asymmetry between firms and

bondholders.

[Insert Table 8]

Third, if CSR helps to mitigate the information asymmetry related to a firm’s reputation, one

would expect that our results would be more pronounced for low-rating bonds. Many bond

portfolio managers are restricted from purchasing low-grade bonds (Grinblatt and Titman, 2002),

29  

and if firms receive a low bond rating – perhaps indicating heavy information asymmetry, poor

quality, and higher risk – they will incur significant financing costs. In the case of low-rating

bonds, then, the effect of CSR on bond contracts is potentially more critical. The role of

reputation should have a greater covenants-reducing effect (or quality-improving effect) for

poorly rated bonds than for highly-rated bonds. We define firms issuing bonds rating below

(above) the median in our sample as having high (low) information asymmetry. As Table 9

presents, the coefficients on the interaction between low-rating bonds indicators and CSR scores

are significantly negative (except for event covenants), indicating that our results in Table 3 are

more pronounced for low-rating bonds with high information asymmetry between firms and

bondholders.

[Insert Table 9]

Fourth, if CSR helps to mitigate the information asymmetry related to a firm’s reputation, one

would expect that our results would be more pronounced during economic shocks. When

establishing credit risk under abnormal circumstances, CSR serves as a signal of reputation. We

explore this by comparing the recent financial crisis period (2007-2009) with the pre-crisis

period (1991-2006) which saw no severe recession lasting for an extended period of time.34 We

expect the covenants-reducing effects of CSR scores to be stronger in the crisis period than in the

pre-crisis period, and our results in Table 10 confirm this: the interaction variables between

financial crisis indicators and CSR scores are significantly and negatively associated with the

numbers of all four categories of covenants.35

[Insert Table 10]

                                                            34 While recessions did occur between 1991 and 2010 (e.g., the 2001 Internet bubble), they typically lasted for a much shorter period of time and had less of an impact relative to the 2007-2009 crisis.  35 We delete the observations for 2010. It is not clear whether to classify it as a time of financial crisis. In any case, the results are not changed when the observations for 2010 are added as crisis period samples or as non-crisis period samples. 

30  

Finally, if CSR helps to mitigate the information asymmetry related to a firm’s reputation, one

would expect that our results would be more pronounced for firms that locate in rural areas.

Bondholders can acquire some soft information about an urban firm, and there tend to be more

business or social interactions between them, but firms that locate in rural areas do not have

these advantages. Francis, Hasan, and Waisman (2008) find that firms headquartered in remote

rural areas exhibit significantly higher at-issue yield spreads. Firms in urban areas benefit from

the large number of mutual funds and financial professionals clustered in big cities or financial

centers such as New York, Los Angeles, Chicago, and San Francisco. Ghoul, Guedhami, Ni,

Pittman, and Saadi (2012) find that equity financing is cheaper for firms nearer to such locations.

A firm is classified as a rural firm if the company headquarters is not in one of the 20 largest US

metropolitan areas (based on population size reported in the 2000 Census). 36 Our results

(untabulated) show that the interaction variables between rural firms indicators and CSR scores

are significantly and negatively associated with the numbers of total covenants, investment

covnants and dividend covenants.

4.7 Alternative explanations

One alternative explanation for our results in Table 3 is that CSR affects bond covenants through

its corporate governance role. The results could be driven by the reduction of agency costs

achieved by stakeholder monitoring. In other words, when CSR investment increases, stronger

ties between firms and stakeholders are established, allowing stakeholders to monitor

management better. If indeed stakeholder monitoring drives the results in Table 3, one would

expect the results to be stronger in durable than nondurable industries, because stakeholder

relations in the former tend to be longer-term, which in turn provides more incentives and

                                                            36 Again, we define a firm’s location as the location of its headquarters. We lose 38 observations since the county names and codes of some firms are missing in the Compustat database and therefore end up with 2097 observations. 

31  

opportunities for stakeholder monitoring (Cremers, Nair, and Peyer, 2008). When we construct

samples of manufacturing and retail companies in durable and nondurable industries using the

classification of Yogo (2006)37 and then rerun our main tests with interaction variables for

durable industry indicators and CSR scores, we find that the coefficients on the interaction

variables are not marginally significant and most of them are positive.

If CSR helps to reduce bond covenants through the corporate governance role, one might

expect that the influence of CSR on bond covenants would be more important for firms that

already have low levels of external and internal monitoring. Alternatively, the influence of CSR

might be substituting for other forms of external and internal monitoring. We use the level of

institutional investor ownership as a proxy for external monitoring. We obtain institutional

ownership data from Thomson and define firms in our sample with below (above) the median

dedicated institutional ownership for one quarter prior to the bond issuing date as having low

(high) external monitoring. However, the coefficients on the interaction variables are not

marginally significant and some of them are positive. When we use two variables, GIM index

and monitoring-intensive board (Faleye, Hoitash, and Hoitash, 2011), 38 as a mechanism of

internal corporate governance, it is no significantly negative association between the number of

bond covenants and the interaction variable for low internal monitoring indicators and CSR

scores.

Another explanation for the results in Table 3 is the overinvestment hypothesis, namely that

overinvestment in CSR represents misuse of firm resources and costly diversions of firm value-

maximization. Managers overinvest in CSR and gain private benefits at the expense of

                                                            37 The two-digit SIC codes for durable industries are: 25, 36, 37, 39, 50, 52, 53, 55, and 57. The two-digit SIC codes for nondurable industries are: 20, 21, 22, 23, 26, 27, 28, 31, 51, 54, 56, 58, and 59. 38 The “monitoring-intensive board” variable equals one when a majority of independent directors are monitoring-intensive, zero otherwise. Monitoring-intensive directors are independent directors serving on at least two of the three principal monitoring committees (audit, compensation, and nominating).  

32  

shareholders (Barnea and Rubin, 2010); this is true especially for firms with severe agency

problems between managers and shareholders. Goss and Roberts (2011) find that low-quality

borrowers pay more for loans when the investments in CSR strengths increase, consistent with

the agency-theoretic overinvestment hypothesis. Chava, Kumar, and Warga (2010) find manager

entrenchment to be negatively related to the use of dividend payouts and subsequent financing

covenants. The flip side of this is that higher CSR investment might be positively associated with

manager entrenchment that reduces dividend payouts and subsequent financing covenants.

Following Chava, Kumar, and Warga (2010), we measure manager entrenchment using long

CEO tenure (where CEOs in the top decile of our sample in terms of tenure are identified

through a dummy variable) and CEO duality (where the CEO is also the chairman of the board),

we find the coefficients of interaction variables are not significant.

Another argument might be that good firms have similar characteristics. For instance, high-

performing firms might hold more cash and invest more in CSR, obtain a higher credit rating and

have fewer bond covenants. So perhaps our results are dominated by high-performing firms. To

address this we divide the entire sample into two groups and obtain a high-performance dummy

(measured as one when ROA is greater than the median of the entire sample, zero else). our

results (untabulated) show that the cefficients of interaction variables between high-performance

indicators and CSR scores are not significant, indicating that our results are not pronounced to

firm with high performance.

Overall, then, these results are inconsistent with alternative notions that the effects of CSR

scores on covenants might be driven by stakeholder monitoring, corporate governance, manager

entrenchment, and good performance.

33  

5. Conclusion

This article examines whether corporate social responsibility (CSR) investment affects a firm’s

bond covenants. We contend that, ceteris paribus, high CSR firms should have fewer bond

covenants than low CSR firms, since high CSR firms signal a credible reputation, mitigating the

information asymmetry between bondholders and insiders. Using a sample of 2,135 bond-level

observations of US firms from 1991 to 2010 and controlling for other bond-specific, firm-

specific determinants as well as industry and year fixed effects, we find that firms with higher

CSR scores enjoy less restriction and more financial flexibility without more covenants when

those firms issue bonds. Furthermore, we find that only CSR investment in the categories of

community, governance, diversity, employee relations, environment, human rights and product

strategies is strongly related to number of bond covenants. In addition, the strengths score is

associated with fewer bond covenants, and the concerns score is associated with more bond

covenants. Thus, having both more strengths and fewer concerns contributes to less bond

restriction. We find that these results are robust to a variety of specifications and tests addressing

endogeneity issues. Our results are even more pronounced for firms with high bid-ask spread of

traded bonds and low analyst coverage, firms issuing low-rating bonds, firm experiencing

economic shock, and firms in rural areas, all of which is consistent with the argument that CSR,

as a signal of a firm’s reputation and credibility, mitigates the information asymmetry between

firms and bondholders. One might propose that CSR affects bond covenants through its

alternative roles. After taking a closer look at durable industry, low levels of external and

internal monitoring, high management entrenchment and high performance, however, the results

do not support the notion that effects of CSR scores are driven by stakeholder monitoring,

corporate governance, manager entrenchment and good performance.

34  

The demonstrated effect of CSR in reducing information asymmetries in bond contracts

suggests an incentive for firms to adjust their levels of CSR investment in order to benefit from

this effect when they look for debt financing. There may be some offsetting costs preventing

firms from adjusting the CSR investment, and these costs must be compared with the costs of

firm-bondholder conflict and be considered in a firm’s decision-making. There is also the

possibility that other channels play a similar role to CSR in mitigating the firm-bondholder

conflict. Therefore, it is worth exploring the tradeoffs between different types of costs and

exploring substitute or complementary relations among different channels, keeping in mind the

important implications for practitioners and policy makers.

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Appendix: Variables definitions Variable Descriptions Sum of all covenants

Sum of all covenants equals the total number of dividend covenants, investment covenants (including merger covenants), subsequent financing covenants, and event covenants a bond has.

Investment covenants

Investment covenants include restrictions on consolidation or mergers, indirect investment, securing the bond, stock sales, and direct investment. Indirect investment restriction category includes restrictions on transactions with affiliates, fixed charge coverage, maintenance of minimum net worth, restrictions on redesignating subsidiaries, subsidiary fixed charge coverage ratio, and the after acquired property clause (that mandates that the property acquired after the current debt issue is sold would be included in the current issuers mortgage).

Dividend covenants

Dividend covenants restrict dividends and other payments.

Subsequent financing covenants

Subsequent financing covenants include debt priority restrictions, stock issuance restrictions, subordinate debt restrictions, and restrictions on sale and lease obligations. Debt priority restriction category includes restrictions on funded debt, indebtedness, liens, and senior debt issuance of parent and subsidiary firms. The stock issuance restriction category includes restrictions on issuance of stock and preference stock of parent and subsidiary firms. The subordinate debt restriction category includes subordinate debt issuance, net earnings test, leverage test, subsidiary borrowings, subsidiary guarantees, subsidiary leverage test, and the negative pledge covenant (i.e., the issuer cannot issue secured debt unless it secures the current issue on a pari passu basis).

Event covenants Event covenants include restrictions falling under default-related event and restriction on the change in control poison put. The default-related event restriction category includes cross default, cross acceleration, rating decline trigger put, and declining net worth covenant.

CSR CSR score is formed by subtracting each firm’s concern score from its strength score. The strength score is the points a firm receives on the community, corporate governance, diversity, employee relations, human rights, environment, and product strength in the KLD database and the concern score is the points on the community, corporate governance, diversity, employee relations, human rights, environment, and product concern.

Bond yield spread

The difference between the issue's offering yield to maturity and the yield on U.S. Treasury bond of comparable maturity on the issuance date (in basis points)

Pvtplacement Dummy when the issue is privately placed (rule 144A) debt.

Log(maturity) Log of maturity (year) of debt.

Log(offering amount)

Log of issue offering amount of debt.

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Credit rating Credit rating is the average credit rating of the bond provided by three rating agencies in FISD database: S&P, Moody’s, and Fitch. If the rating of issue is missing, it is replaced in by the average credit rating of the issuer or is replaced by S&P long-term issuer rating from Compustat. We use the residual of bond rating on CSR variables in regression. We convert the credit rating into a numerical scale as follows: 21-AAA, 20-AA+, 19-AA, 18-AA-, 17-A+, 16-A, 15-A-, 14-BBB+, 13-BBB, 12-BBB-, 11-BB+, 10-BB, 9-BB-, 8-B+, 7-B, 6-B-, 5-CCC+, 4-CCC, 3-CC, 2-C, and 1-D&SD.

Putable Dummy variable equals one if the bond is putable, and zero otherwise.

Callable Dummy variable equals one if the bond is callable, and zero otherwise.

Log(Mtb) log(Compustat #199* Compustat #25/ data60). Missing market-to-book values are replaced with the sample average.

Lev Total debt (Compustat #9 plus Compustat #34) divided by total assets (Compustat #6).

Roa Net income before extraordinary items (Compustat #18) divided by total assets.

Size Log of total assets.

Subord One if the firm has subordinated debt, zero otherwise.

Cap_inten Gross PPE (Compustat #7) divided by total assets.

Institutional holdings

Institutional holdings equal to the number of shares held by institutions divided by shares outstanding in the quarter prior to the bond issuance.

block holders One if there is at least one financial institution that holds over 5% of a firm's outstanding shares as of the quarter prior to the bond issuance, and zero else.

GIM-index GIM-index equals to the sum of 24 anti-takeover provisions from the IRRC database and is available for the years 1990, 1993, 1995, 1998, 2000, 2002, 2004, and 2006. For intermediate years, we use the GIM-index from the most recent year.

KZ score Following Baker, Stein, and Wurgler (2003) and Hong, Kubikz, and Scheinkman (2012), the KZ Score is constructed for each firm-year as linear combinations using five variables (cash flow, cash dividend, cash balances, book leverage and Tobin’s Q).

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