Covenant Violations and Dynamic Loan Contracting
74 Pages Posted: 20 Nov 2011 Last revised: 24 May 2017
Date Written: May 19, 2017
This paper examines the dynamic allocation of control rights in private debt contracts of firms that repeatedly borrow in the syndicated loan market. We show that a covenant violation in the prior loan contract provides a signal to creditors which results in stricter contract terms for the subsequent new loan. This signal is neither related to unobservable nor to observable firm characteristics at the initiation of the new loan, such as for example credit risk. It also does not reflect agency problems between the lender and firm management, shareholders or public debtholders. After covenant violations in the prior contract, new loans have on average 18bps higher spreads and include more of those covenant types which also have been violated in the prior contract, with tighter thresholds. Our findings reveal that a prior covenant violation is a stigma for borrowers which results in stricter loan contract terms in subsequent new loan contracts.
Keywords: Control Rights, Covenant Violation, Dynamic Loan Contracting, Stigma
JEL Classification: G21, G32, L14
Suggested Citation: Suggested Citation