Agency Cost of Debt: Conflicts, Covenants, and Lender Tools

The agency cost of debt is the value a company loses, and the extra price it pays to borrow, because the people who control its decisions (shareholders) and the people who lend it money (creditors) want different things. Shareholders benefit most when the company takes big risks; creditors just want to be repaid. Lenders know shareholders have an incentive to act against them once the money is out the door, so they build that expectation into the interest rate, demand collateral, and write restrictive covenants into the loan agreement. Michael Jensen and William Meckling, writing in 1976, broke the total cost into three pieces: value destroyed by distorted investment decisions, the cost of monitoring and bonding to prevent those distortions, and whatever loss slips through anyway.¹

Why the Conflict Exists

Creditors hold a fixed claim. They receive principal and interest no matter how well the business does. Shareholders hold the residual claim, meaning they get whatever is left after debts are paid. If the company thrives, shareholders capture the entire surplus. If it collapses, shareholders lose only what they put in, and creditors absorb the shortfall.

Jensen and Meckling described this arrangement by noting that shareholders effectively hold a call option on the firm’s value, with a strike price equal to the face value of the debt.¹ Like any option holder, shareholders benefit from volatility. The wider the range of possible outcomes, the more valuable their position becomes. That option-like payoff is the root of every specific problem that follows.

Asset Substitution: Taking On Extra Risk After Borrowing

Once a loan is issued at terms based on a certain risk profile, shareholders have reason to swap safer assets or projects for riskier ones. If the gamble works, they keep the upside. If it fails, creditors absorb the loss.

The mechanics are easiest to see with numbers. Consider a company in distress with assets worth $90 million and debt of $100 million. Shareholders are already wiped out on paper. A safe project with a positive net present value of $5 million would raise firm value to $95 million, but shareholders still get nothing because that is less than the $100 million owed. Creditors would recover $95 million instead of $90 million, so the safe project helps them and no one else.

Now compare a risky alternative with a negative expected value: a 10% chance of a $200 million payoff and a 90% chance of losing $10 million. If it hits, firm value jumps to $290 million, shareholders take $190 million after paying creditors in full, and creditors are made whole. If it fails, firm value falls to $80 million, and creditors lose an extra $10 million.

Shareholders pick the risky project every time. It destroys expected firm value, but it raises the expected value of their piece. Lenders know this pattern exists, and they price it into the interest rate at closing. The premium is real whether or not any given borrower actually does it.

Debt Overhang: Passing Up Good Projects

The mirror problem is that heavily indebted shareholders reject investments that would create value, because most of the gain would go to creditors. Stewart Myers identified this in 1977.

Say a company can invest $10 million of new equity in a project worth $15 million in net present value. If existing debt already exceeds firm value, the entire $15 million gain flows to creditors by making shaky debt more secure. Shareholders fund the outlay and see nothing extra in a sale or liquidation. So they walk away, and the $15 million never gets created. High debt-to-equity firms are especially vulnerable, which is one reason overleveraged companies often stop investing even when opportunities are sitting in front of them.

How the Cost Shows Up in the Interest Rate

Agency costs aren’t abstract. They land inside the credit spread a company pays above the risk-free rate. Research on corporate bond markets has found that debt with restrictive covenants carries meaningfully lower interest rates, which means investors treat the absence of covenants as a distinct risk they charge for. One study estimated the default probability on covenant-free debt at roughly 64 basis points higher than comparable debt with covenants.²

The trade is straightforward. Accept covenants and give up flexibility, in exchange for a cheaper rate. Refuse them and keep the freedom, but pay for it on every dollar borrowed. The agency cost is priced into the deal one way or the other.

Covenants: The Main Control Mechanism

Loan covenants are contractual promises inside the loan agreement. Negative covenants tell the borrower what it cannot do. Affirmative covenants tell it what it must do. Together they limit the shareholder actions that would transfer wealth from creditors.

Negative Covenants

Typical negative covenants cap additional borrowing (so the lender’s claim doesn’t get diluted by new senior debt), restrict sales of core assets (so the collateral base stays intact), and limit dividend payments (so shareholders can’t drain cash right before trouble hits). A dividend restriction directly blocks the most obvious channel for wealth extraction on the way down.

Affirmative Covenants

The most consequential affirmative covenants are financial maintenance covenants, which require the borrower to stay above or below defined ratios such as a minimum debt service coverage ratio or a maximum debt-to-assets ratio. Cross a threshold and the lender gets rights. Others require audited financials on a schedule, adequate insurance on pledged assets, and legal compliance. These give the lender early warning of problems that might otherwise stay hidden.

When a Covenant Is Broken

A covenant breach is a default under the loan agreement, even when no payment has been missed. That so-called technical default gives the lender contractual rights. Most agreements include an acceleration clause, which lets the lender demand immediate repayment of the entire outstanding balance after a breach. Acceleration is rarely automatic; the lender chooses whether to invoke it based on how serious the breach is and how the borrower looks going forward.³

When acceleration is invoked, the borrower owes unpaid principal plus interest accrued to that point, not future interest that would have come due over the remaining loan life. Borrowers can sometimes cure the violation before the lender formally acts.³ In practice, lenders often prefer negotiating amendments, forbearance, additional collateral, or a restructuring adviser over outright acceleration. The harshest outcomes are reserved for cases with no realistic recovery path.

Other Tools Lenders Use

Collateral

A security interest in specific assets makes asset substitution harder. The borrower can’t swap pledged equipment or property for something riskier without breaching the security agreement. Collateral also reduces the lender’s loss on default, which lowers the risk premium built into the rate. Research has confirmed that collateral mitigates conflicts of interest in lending, though it constrains borrowers by limiting how freely they can redeploy assets.⁴

Convertible Debt

Convertible bonds let creditors convert to equity if the stock price rises above a set level. That neutralizes asset substitution: if shareholders take a big risk and win, convertible holders share in the upside by converting. The one-sided payoff that makes risk-shifting attractive disappears. In exchange, convertible debt usually carries a lower coupon, so existing shareholders accept potential dilution to lower their borrowing cost.

Monitoring

Monitoring expenditures were one of the three cost components Jensen and Meckling identified.¹ In practice, monitoring means required audits, regular financial reporting, site inspections, and ongoing credit analysis. The costs land on the borrower through fees or the rate itself. Both sides accept them because they’re usually cheaper than the wealth destruction they prevent.

The Tax Deduction Doesn’t Fully Cancel the Cost

Business interest expense is generally deductible, which softens the sting of a higher rate. The deduction is not unlimited. Under Section 163(j), a company’s deductible business interest in a given year is capped at the sum of its business interest income, 30% of adjusted taxable income, and any floor plan financing interest.⁵

For tax years beginning in 2026, adjusted taxable income uses the narrower EBIT-based definition rather than the EBITDA-based formula that applied through 2021. Depreciation and amortization are no longer added back, which tightens the cap for capital-intensive firms.⁶ The result: the agency-driven interest premium is only partly offset by tax savings, and the after-tax cost of debt for a leveraged firm with heavy agency friction runs higher than a simple deductibility assumption would suggest.⁵

1
Simon Fraser University. Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure
2
Harvard Business School. Corporate Refinancing, Covenants, and the Agency Cost of Debt
3
Legal Information Institute. Acceleration Clause
4
Federal Deposit Insurance Corporation. The Shadow Cost of Collateral
5
Office of the Law Revision Counsel. 26 USC 163 – Interest
6
Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense