The Screening Role of Covenant Heterogeneity
59 Pages Posted: 30 Oct 2015 Last revised: 13 Apr 2019
Date Written: March 31, 2019
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: Suggested Citation