Debt covenant violation and default risk

This large sample study on US firms examines the impact of corporate debt covenant violations on firm default risk. Using a Difference-in-Difference research design, we find a significant lower level of default risk 12 months after the violation month/quarter. However, the change becomes economically and statistically insignificant when we use propensity-score-matching method to match violators to non-violators. The selection of a control group is based on propensity scores matched on firm and covenants characteristics as well as time and industry fixed effects. Our results remain unchanged and are consistent when different measures of default risk (e.g., estimated by the Merton model using trading data, and by the Altman (1968) model using accounting data respectively) are used; and are robust across various matching criteria