Working Paper: NBER ID: w29888
Authors: Falk Bruening; Victoria Ivashina; Ali Ozdagli
Abstract: High-yield debt including leveraged loans is characterized by incurrence financial covenants, or “cov-lite” provisions. A traditional loan agreement includes maintenance covenants, which require continuous compliance with the covenant threshold, and their violation shifts the control rights to creditors. Incurrence covenants preserve equity control rights but trigger pre-specified restrictions on the borrower’s actions once the covenant threshold is crossed. We show that the prevalence of incurrence covenants indirectly imposes significant constraints on investments as restricted actions become binding: Similar to the effects associated with the shift of control rights to creditors in traditional loans, the drop in investment under incurrence covenants is large and sudden. The deleveraging and drop in investment and market value associated with such latent violations point to a shock amplification mechanism through contractual restrictions that are at play for a highly levered corporate sector prior to firms filing for bankruptcy and independently of whether they ever do so.
Keywords: No keywords provided
JEL Codes: G21; G31; G32; G33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Triggering incurrence covenant restrictions (G33) | Drop in investment rates (F21) |
| Triggering incurrence covenant restrictions (G33) | Decrease in capital expenditures (G31) |
| Violation of maintenance covenant (K36) | Drop in investment rates (F21) |
| Triggering incurrence covenant restrictions (G33) | Decrease in debt-to-assets ratio (G32) |
| Violation of maintenance covenant (K36) | Decrease in debt-to-assets ratio (G32) |
| Covenant violations (K42) | Decline in equity returns (G12) |