Why Do Parent Companies Guarantee Their Subsidiaries’ Bonds? The Dark Side of Separate Legal Liability

Parent guarantees to subsidiary bond issues can circumvent restrictive covenants on parent debt, and transfer wealth from bond- to equity-holders or maximize parent managers’ private benefits. We find that parent firms expecting stringent covenants on their own debt more likely guarantee subsidiary bonds, and less likely when the pressure from covenants attenuates. Parent bond and stock prices drop after guaranteed subsidiary bond issues. Following such issues parents do not increase payout or risk, but more likely undertake acquisitions. These results suggest that the benefits of limited liability are balanced by the potential agency costs that it creates.