Working Paper

High-Yield Debt Covenants and Their Real Effects

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 rights 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.

Keywords: high-yield debt; corporate debt; covenants; incurrence covenants; cov-lite; amplification mechanisms; contracts; contingent contracting;

JEL Classification: G21; G31; G32; G33;

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Bibliographic Information

Provider: Federal Reserve Bank of Boston

Part of Series: Working Papers

Publication Date: 2022-03-01

Number: 22-5