Weak Credit Covenants

Abstract

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.

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