Covenant-lite agreement and credit risk: A key relationship in the leveraged loan market

Abstract

In recent years, the leveraged loan market has experienced considerable growth, with the covenant-lite loan being the predominant agreement. The goal of this research is to assess whether the covenant-lite type reduces or increases the probability of default. Mediation analysis allows us to decompose the effect of balance sheet indicators on a default event into direct and indirect effects, the latter mediated by the covenant-lite. Results show that the covenant-lite is granted to borrowers with a greater profitability. In turn, all other conditions being equal, this agreement plays a role in making a default event less likely, giving rise to a significant indirect effect.