The Price Effects of Event Risk Protection: The Results from a Natural Experiment

Abstract

Prior studies have generally agreed that bond prices reflect both the event risk faced by the holders of a particular issuer’s debt securities and the degree of protection from event risk contained within the terms of the bond. Therefore, it has been found that bonds without event risk protection command a premium over comparable bonds with “change in control puts” or similar protective covenants. Although prior studies have reached this common conclusion, each has struggled with a common problem. The decision to include protective covenants is endogenous. Bonds facing the highest event risk are likely to be those for which event risk protection is most highly valued. Therefore a determination of the pricing effect of event risk protection must somehow control for the differing degree of event risk faced by the different bonds included in any given study’s sample. While various proxies for the likelihood of an event, a leveraged buyout or recapitalization, have been developed, they are by their nature imprecise. A recent event, a series of court decisions regarding the proposed leveraged buyout of Bell Canada, the largest LBO transaction announced in history, provides a natural experiment for evaluating the pricing effect of event risk protection in corporate bonds that avoids the endogeniety problem. We report the results of that experiment in this paper.