The Screening Role of Covenant Heterogeneity

59 Pages Posted: 30 Oct 2015 Last revised: 13 Apr 2019

See all articles by Chris Armstrong

Chris Armstrong

University of Pennsylvania - Accounting Department

Carlo Maria Gallimberti

Boston College

David Tsui

University of Southern California - Marshall School of Business

Date Written: March 31, 2019

Abstract

We show that the mix of financial covenants included in debt contracts is informative about borrowers’ future risk-taking. Borrowers with a greater proportion of input-based covenants that restrict the amount, but not the riskiness, of investment make riskier future investments. Conversely, borrowers with a greater proportion of output-based covenants that depend on investment outcomes invest in safer projects. We find that these differential relations arise primarily because the mix of financial covenants reflects borrowers’ pre-contractual risk-taking intentions and, consequently, variation in covenant mix can help lenders mitigate adverse selection when contracting with borrowers. Collectively, our findings provide new insight into the nature and purpose of the observed heterogeneity in debt covenants.

Keywords: risk-taking incentives; debt contracting; debt covenants; covenant violations; agency conflicts; risk shifting; moral hazard; adverse selection; screening; credit spreads

JEL Classification: G21, G32, G34

Suggested Citation

Armstrong, Chris S. and Gallimberti, Carlo Maria and Tsui, David, The Screening Role of Covenant Heterogeneity (March 31, 2019). Available at SSRN: https://ssrn.com/abstract=2681930 or http://dx.doi.org/10.2139/ssrn.2681930

Chris S. Armstrong (Contact Author)

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

Carlo Maria Gallimberti

Boston College ( email )

140 Commonwealth Avenue
Chestnut Hill, MA 02467
United States

David Tsui

University of Southern California - Marshall School of Business ( email )

3660 Trousdale Parkway
Los Angeles, CA 90089
United States

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