Weak Credit Covenants
Using novel data on 1,240 credit agreements, we investigate sources of contractual complexity in the leveraged loan market. While negative covenants are widespread, carve-out and deductible clauses that weaken them are as frequent. We propose simple measures of contractual weakness, which uniquely explain the market-wide price reaction that followed the 2017 J.Crew restructuring, a high profile use of such contractual elements. Leveraged buyouts have significantly weaker loan agreements, and a larger non-bank funding of a loan is conducive to weaker contractual terms. Weak covenants translate to modestly higher issuance spreads. Overall, our findings are consistent with sophisticated borrowers catering to a reaching-for-yield phenomenon by exploiting contractual complexity.
We are grateful to Patrick Bolton, Jonathan Cohn (FIRS discussant), Croci Ettore (discussant), Viktar Fedaseyeu (discussant), Denis Gromb, Andres Liberman (discussant), Greg Nini (WFA discussant), Mike Schwert, seminar and conference participants at Harvard University, Booth/Chicago University, Stern/New York University, Northwestern University, University of Minnesota, University of St Gallen, Ludwig Maximilian University, the 2019 WFA, the 2019 FIRS, the 2018 EFA meetings, the 2017 Yale Junior Finance Conference and the 2017 Paris Finance meeting. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.