“Stepping Stone” or “Stumbling Block”: Can Bond Covenants Alleviate Corporate Under-investment?
GUO Jing, ZHANG Xinmin, WU Lingyan
Intelligent Management Accounting Institute, Shanxi University of Finance and Economics; Business School/Beijing Enterprises’ Global Management Research Centre, University of International Business and Economics
Summary:
Investment is a strategic pillar of high-quality economic development. At present, corporate under-investment in China has continued to worsen. The growth rate of fixed-asset investment across China decreased from 17.3% in 2013 to -3.8% in 2025. From January to December 2025, the purchasing managers' index (PMI) for China's manufacturing sector remained below the 50-point threshold for nine months, with weak effective demand and insufficient corporate willingness to invest exerting dual pressures. The lack of investment may not only cause enterprises to miss growth opportunities, hindering the effective flow of capital to the real economy, but also suppress household employment and income growth, constrain the release of demand potential from the supply-side and further weaken the endogenous power of economic development. Demand-side reform, such as consumption stimulus policies, can stabilize market expectations and boost investment. Nevertheless, to fundamentally address enterprises' core dilemma of inadequate investment capacity due to financing constraints and contractual frictions, it is still necessary to rely on supply-side reforms. These measures can in turn drive consumption upgrading, stimulate corporate investment, and foster a virtuous cycle between market demand and supply, by expanding employment and raising labor compensation. Therefore, unblocking investment bottlenecks from the supply-side perspective has become a critical practical challenge in the current context of stabilizing growth and promoting development. Bond covenants constitute a core mechanism in bond contracts for balancing the interests of creditors and debtors. In China, bond covenants consist of two types: creditor-protection covenants, which are designed to safeguard creditors’ interests, and debtor-protection covenants, which serve to protect the interests of issuing firms. Owing to the inherently conflicting interests of their respective beneficiaries, the two types of covenants differ fundamentally in their allocation of rights. The former controls agency risk by restricting corporate behavior, while the latter enhances financial flexibility by granting enterprises autonomy. This likely results in differential impacts on corporate investment decisions. Current research predominantly analyzes bond covenants as a single homogeneous group, overlooking the systematic differences between the two types of bond covenants. Meanwhile, existing literature focuses only on single-dimensional aspects such as “investment decision constraints” or “agency risk mitigation”, failing to explain the nonlinear relationship between creditor-protection covenants and investment efficiency. In conclusion, this paper takes micro-level data from A-share listed firms issuing corporate bonds in China between 2007 and 2021 as the research sample. It classifies bond covenants into creditor-protection covenants and debtor-protection covenants according to the protected parties to investigate the effects and underlying mechanisms of bond covenants on corporate under-investment. First, we establish a dual analysis framework of benefits and costs for creditor-protection covenants along two dimensions: financing cost reduction and decision-making constraints. These covenants can send a positive signal to the market about the sound operation of enterprises, thus reduce bond financing costs and encourage enterprises to invest, by constraining opportunistic behavior of shareholders and managers. However, they can also reduce corporate decision-making flexibility, thereby inhibiting firms’ capacity for optimal decisions and leading to the loss of valuable investment opportunities. Second, we analyze the effectiveness of debtor-protection covenants from two aspects:enhanced financial flexibility and risk premium transmission. These covenants can provide financial flexibility to mitigate under-investment caused by maturity mismatch. However, with the transfer of rights, they may also increase the uncertainty of creditors’ cash flows, further pushing up the bond risk premium and reducing space for corporate investment. The results are as follows. First, there is a positive U-shape relationship between creditor-protection covenants and corporate under-investment. This means that moderate protection for creditors can alleviate under-investment, like a stepping stone. However, excessive protection becomes a stumbling block, which can weaken the investment willingness of enterprises.These negative effects of creditor-protection covenants on under-investment can be attenuated by a good business environment, effective corporate governance, state-owned ownership and heavy-asset operation. Second, debtor-protection covenants have an aggravating effect on under-investment. The effect can be mitigated when macro interest rates decline or enterprises exhibit weak short-term solvency. Third, the classification research of creditor-protection covenants shows that both preventive restriction covenants and preventive option covenants have a positive U-shaped influence on under-investment, and remedial restriction covenants can significantly stimulate corporate investment. The policy implications of this study are threefold. First, use bond covenants moderately to stimulate enterprise investment. When formulating bond indentures, enterprises shall adhere to long-term development strategies, comprehensively consider the multi-dimensional impacts of covenants and guard against adverse effects arising from excessive decision-making constraints or risk premiums. Second, enhance the application of quantitative indicators to improve the binding force and enforceability of covenants. Regulatory authorities and self-regulatory organizations should strengthen formatting guidelines for bond covenants to encourage enterprises to establish explicit quantitative thresholds for financial indicators within bond covenants. They should also closely monitor the legal validity and enforcement of such covenants in the market. For vague and dispute-prone general covenants, risk warnings may be introduced as appropriate. Third, continuously promote effective market development and strengthen the protection of creditors' rights. This study finds that a favorable business environment, along with sound corporate governance mechanisms, can significantly mitigate the negative impacts of creditor-protection covenants on corporate investment. Therefore, supporting institutions should be further developed and improved.
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