Signaling through Dynamic Thresholds in Financial Covenants

Abstract

ABSTRACT Among loan contracts originated during 1996–2015 with covenants, 37 percent have financial covenant thresholds that automatically tighten according to a predetermined schedule. Firms that accept dynamic covenant thresholds improve their creditworthiness, but they are more likely to violate covenants relative to matched control firms. In the event of a covenant violation, these firms are less likely to receive a waiver. They also tend to pay higher waiver fees, experience greater investment cuts, reclassify more debt as callable within one year, and they are more likely to switch lead lenders. Overall, our findings suggest that, on average, signaling through dynamic thresholds in covenants is credible but costly to borrowers should they fail to deliver the signaled performance. JEL Classifications: G14, G21, G32, G34, M41.