When Are Financial Covenants Relevant?

44 Pages Posted: 17 Mar 2020

See all articles by Sergei A. Davydenko

Sergei A. Davydenko

University of Toronto - Finance Area

Redouane Elkamhi

University of Toronto - Rotman School of Management

Marco Salerno

University of Toronto - Rotman School of Management

Date Written: February 28, 2020

Abstract

This paper shows that financial covenants have no value for creditors of highly levered firms, because an attempt to enforce their rights in technical default would result in a lower payoff than continued operations under shareholders' control. This explains the widespread use of cov-lite loans by junk firms. By contrast, for investment-grade firms tightly set covenants allow creditors to demand full repayment while the firm is still solvent. This ensures that creditors sustain no loss regardless of the underlying default probability, mitigating their concerns about the firm's financial health and alleviating adverse selection in lending. We show that the optimal strictness of financial covenants is hump-shaped in the firm's leverage.

Keywords: Corporate Loans; Covenants; Covenant strictness; Cov-lite

JEL Classification: G23, G32

Suggested Citation

Davydenko, Sergei A. and Elkamhi, Redouane and Salerno, Marco, When Are Financial Covenants Relevant? (February 28, 2020). Available at SSRN: https://ssrn.com/abstract=3554454 or http://dx.doi.org/10.2139/ssrn.3554454

Sergei A. Davydenko (Contact Author)

University of Toronto - Finance Area ( email )

Toronto, Ontario M5S 3E6
Canada

Redouane Elkamhi

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

Marco Salerno

University of Toronto - Rotman School of Management ( email )

Toronto, Ontario M5S 3G8
Canada

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