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.
Key Findings
- In the paper's sample of firms, the investment rate drops about 1.8 percentage points when incurrence covenant restrictions are triggered, as compared with 0.9 percentage point when a maintenance covenant is violated.
- After either violating a maintenance covenant or triggering incurrence covenant restrictions, firms significantly deleverage. In the paper's sample, the debt-to-assets ratio decreases by about 1.6 percentage points on average when a firm violates a maintenance covenant. However, triggering incurrence covenant restrictions leads to a reduction in the debt-to-assets ratio of about 2.7 percentage points.
- Triggering incurrence covenant restrictions and violating maintenance covenants both lead to a significant decline in equity returns of about 6 percentage points, which is consistent with the role that covenants play in preserving creditors' debt value.
- The deleveraging and the decline in equity returns occur suddenly following incurrence covenant triggers, just as they do after maintenance covenant violations.
Implications
This paper adds to the research on how negative shocks spread through the economy, specifically the studies focusing on mechanisms that operate through firms’ debt. In contrast to the existing literature, however, the authors focus on leveraged loans with an incurrence covenant structure that is very different from the maintenance covenants of traditional loan agreements. They show that the deleveraging and drop in market value associated with incurrence covenant triggers indicate that in a highly leveraged economy there is a novel shock amplification mechanism that does not involve default or bankruptcy.
Abstract
High-yield debt, including leveraged loans, is characterized by incurrence financial covenants, or “cov-lite” provisions. Unlike, traditional, maintenance covenants, incurrence covenants preserve equity control right but trigger pre-specified restrictions on the borrower’s actions once the covenant threshold is crossed. We show that restricted actions impose significant constraints on investments: Similar to the effects of the shift of control rights to creditors in traditional loans, the drop in investment under incurrence covenants is large and sudden. This evidence suggests a new shock amplification mechanism through contractual restrictions that are at play for a highly levered corporate sector long before default or bankruptcy.