The Impact of Dividend Covenants on Investment and Operating Performance

This paper examines the influence of dividend covenants in corporate bonds on investment and operating performance. Prior literature analytically demonstrates that by limiting dividend distribution to shareholders, dividend restrictions effectively place a minimum on investment expenditures. This suggests a positive relation between dividend covenants and investment. The literature also conjectures that the influence of dividend covenants on investment (1) mitigates the under-investment problem associated with debt financing; or (2) exacerbates over-investment. We empirically document that the presence of dividend covenants is associated with a higher level of investment and poorer future performance. Further analyses confirm that the higher level of investment is consistent with dividend covenants exacerbating over-investment, not mitigating under-investment. Our results shed light on the cost aspect of dividend covenants proposed in prior literature.