Dynamic Financial Covenant Thresholds
52 Pages Posted: 23 Jan 2012 Last revised: 16 Jun 2020
Date Written: June 7, 2015
Among loan contracts originated during 1996 – 2015 with covenants, 37% have financial covenant thresholds that automatically tighten according to a predetermined schedule. Firms that accept dynamic covenant thresholds improve their creditworthiness, but they are more likely to violate covenants relative to matched control firms. In the event of a covenant violation, these firms are less likely to receive a waiver. They also tend to pay higher waiver fees, experience greater investment cuts, reclassify more debt as callable within one year, and they are more likely to switch lead lenders. Overall, our findings suggest that, on average, signaling through dynamic thresholds in covenants is credible but costly to borrowers should they fail to deliver the signaled performance.
Keywords: Loan contract design, signaling, adverse selection, covenant thresholds, covenant violations, creditor control
JEL Classification: G14, G21, G32, M41
Suggested Citation: Suggested Citation