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
Date Written: August 31, 2016
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: Suggested Citation