The Screening Role of Covenant Heterogeneity
The Accounting Review, 2025
Efficient credit markets rely, in part, on lenders’ ability to accurately assess borrower risk prior to issuing loans. Lenders with inaccurate or insufficient information about risk face greater potential exposure to unexpected losses, which can lead to credit rationing or other negative outcomes that can disrupt credit markets.
Evaluating borrowers comes with several challenges. One of the main challenges is that riskier borrowers have little incentive to inform lenders about their risk, because lenders generally set higher interest spreads for riskier loans. However, there are tactics that lenders can use to better understand borrowers’ future risk. In The Accounting Review, Analysis Group Managers Carlo Gallimberti and David Tsui and academic affiliate Christopher Armstrong analyzed data on almost 9,000 private loan contracts to evaluate one of these tactics: the use of covenant heterogeneity. Covenant heterogeneity refers to differences across debt contracts in the mix of financial covenants – that is, financial conditions that borrowers must agree to satisfy during the loan period.
Although financial covenants are present in virtually all loan contracts, not all financial covenants are created equal. Loans for different borrowers tend to include different types of covenants: while some borrowers choose requirements related to their quarterly earnings, other borrowers choose requirements based on other financial metrics (e.g., tangible net worth or working capital). The authors theorized that borrowers’ choice of covenants may convey information about their future risk intentions, since greater risk is usually associated with less predictable earnings performance and, thus, a higher likelihood of breaching performance-sensitive covenants.
Consistent with the authors’ hypothesis, the study results suggest borrowers who choose covenants less sensitive to performance tend to have higher future risk. Conversely, borrowers who select covenants more sensitive to performance tend to take on less risk in the future. The study offers deeper insight into a ubiquitous feature of debt contracts that is typically characterized as a way to monitor borrowers, rather than as a tool to assess their risk ahead of loan issuance.