Unemployment Risk and Debt Contract Design

We examine how firms' contractual relationships with their employees affect the design of their debt contracts, and their use of financial covenants and pricing grids in particular. Viewing the firm as nexus of both explicit and implicit contractual relationships, we argue that managers internalize their employees' preferences when negotiating contractual terms with creditors. An increase in unemployment insurance benefits reduces employees' cost of job loss which, in turn, allows managers to take more risk. We find that loans initiated following an increase in unemployment insurance benefits are more likely to include performance rather than capital covenants and are more likely to include pricing grids based on financial (i.e., profitability) ratios rather than credit ratings. Overall, our study demonstrates how the design of debt contracts changes in response to arguably exogenous changes in employees' collective tolerance — and, in turn, managers' preferences — for risk