High-Yield Debt Covenants and Their Real Effects

High-yield debt including leveraged loans is characterized by incurrence financial covenants, or “cov-lite” provisions. A traditional loan agreement includes maintenance covenants, which require continuous compliance with the covenant threshold, and their violation shifts the control rights to creditors. 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 the prevalence of incurrence covenants indirectly imposes significant constraints on investments as restricted actions become binding: Similar to the effects associated with the shift of control rights to creditors in traditional loans, the drop in investment under incurrence covenants is large and sudden. The deleveraging and drop in investment and market value associated with such latent violations point to a shock amplification mechanism through contractual restrictions that are at play for a highly levered corporate sector prior to firms filing for bankruptcy and independently of whether they ever do so.