Abstract
In 40% of private loan contracts, covenant thresholds automatically increase to pre-specified levels over time. Firms accepting these dynamic thresholds receive lower interest rates and higher abnormal stock returns to loan announcements than risk matched firms. The former also experience a reduction in credit risk over three years following loan origination. But, in the event of a covenant violation, they are less likely to receive a waiver and experience greater investment cuts. Our results suggest that time-varying thresholds do not substitute for initial covenant tightness and can help mitigate adverse selection by allowing firms to signal their future risk dynamics.
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