Do Tighter Loan Covenants Signal Improved Future Corporate Results? The Case of Performance Pricing Covenants

Financial Management, Forthcoming

50 Pages Posted: 22 Apr 2013 Last revised: 3 Sep 2016

See all articles by Mehdi Beyhaghi

Mehdi Beyhaghi

Federal Reserve Banks - Federal Reserve Bank of Richmond

Kamphol Panyagometh

NIDA Business School

Aron A. Gottesman

Pace University - Lubin School of Business - Department of Finance and Economics

Gordon S. Roberts

York University - Schulich School of Business

Date Written: August 31, 2016

Abstract

Covenants in corporate bonds and loan agreements mitigate agency conflicts between borrowers and lenders and may provide a signal of borrower quality to help resolve information asymmetry. Performance pricing covenants in bank loans specify automatic adjustments to loan spreads based on borrowers’ subsequent performance. Our covenant signaling framework views interest-decreasing performance pricing as a tight covenant associated with borrowers’ private information on improved future performance accompanied by reduced credit risk. This positive signal is associated with larger positive loan announcement returns and greater improvements in future borrower performance. Further, in addition to signaling value, we find that the spread impact of this class of covenant also depends on its option value and reduction in transaction costs.

Keywords: Covenants, Performance pricing, Loan pricing, Tight covenant, Loan announcement

JEL Classification: G21, G32

Suggested Citation

Beyhaghi, Mehdi and Panyagometh, Kamphol and Gottesman, Aron A. and Roberts, Gordon S., Do Tighter Loan Covenants Signal Improved Future Corporate Results? The Case of Performance Pricing Covenants (August 31, 2016). Financial Management, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2255061 or http://dx.doi.org/10.2139/ssrn.2255061

Mehdi Beyhaghi (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States

Kamphol Panyagometh

NIDA Business School ( email )

118 Seri Thai
Bangkapi
Bangkok
Thailand

Aron A. Gottesman

Pace University - Lubin School of Business - Department of Finance and Economics ( email )

One Pace Plaza
New York, NY 10038
United States
212-346-1912 (Phone)
212-346-1573 (Fax)

Gordon S. Roberts

York University - Schulich School of Business ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3
Canada
416-736-2100 x77953 (Phone)
416-736-5687 (Fax)

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