High-Yield Debt Covenants and Their Real Effects
Traditional loans have maintenance covenants, which require the borrowers to continuously comply with the covenant thresholds (for example, maintaining a leverage ratio below a certain value) every quarter under the threat of transferring control rights to the lenders. In contrast, high-yield debt is characterized by incurrence covenants, which restrict some actions of the borrowers if the covenant thresholds are crossed but do not lead to violations of the contracts and associated shifts in control rights. Therefore, loans that have incurrence covenants often are referred to as “cov-lite” loans, suggesting that the covenants are less restrictive than maintenance covenants. The share of loans in the leveraged-loan market that are cov-lite grew from just over 10 percent in 2007 to more than 80 percent in 2020. While a highly leveraged corporate sector seemingly would play a much less important role in the transmission of shocks when it is dominated by incurrence covenants instead of maintenance covenants, that is not necessarily the case. In this paper, the authors show that in the leveraged-loan market, “latent” violations of incurrence covenants—that is, triggers for restrictions on certain actions—have sizable real effects long before firms default or declare bankruptcy.