The Screening Role of Covenant Heterogeneity

70 Pages Posted: 30 Oct 2015 Last revised: 1 May 2020

See all articles by Chris Armstrong

Chris Armstrong

University of Pennsylvania - Accounting Department

Carlo Maria Gallimberti

Boston College

David Tsui

University of Southern California - Marshall School of Business

Date Written: April 12, 2020

Abstract

We investigate whether the mix of financial covenants in debt contracts allows lenders to screen borrowers based on their private information about their future risk-taking intentions. Consistent with adverse selection theories, we predict and find that borrowers with greater risk-taking intentions prefer covenants that are less dependent on their performance, while safer borrowers prefer performance-based covenants. Further tests show that lenders use these contrasting preferences to screen borrowers, especially when their screening needs intensify. This screening through covenant mix: (i) allows lenders to design more efficient contracts with spreads that better anticipate borrowers’ future repayment abilities; and (ii) is at least as informative as and provides information that is incremental to other common screening mechanisms, such as loan maturity or collateral. By highlighting the use of heterogeneity in covenant mix to mitigate pre-contractual information asymmetry with respect to borrowers’ risk-taking intentions, our study answers recent calls to further explain heterogeneity in debt covenants and how they improve debt contract efficiency.

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

Armstrong, Chris S. and Gallimberti, Carlo Maria and Tsui, David, The Screening Role of Covenant Heterogeneity (April 12, 2020). Available at SSRN: https://ssrn.com/abstract=2681930 or http://dx.doi.org/10.2139/ssrn.2681930

Chris S. Armstrong (Contact Author)

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

Carlo Maria Gallimberti

Boston College ( email )

140 Commonwealth Avenue
Chestnut Hill, MA 02467
United States

David Tsui

University of Southern California - Marshall School of Business ( email )

3660 Trousdale Parkway
Los Angeles, CA 90089
United States

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