Zahn Bozanic

The Ex-Ante Monitoring Role of Accounting Covenants in Public Debt

In contrast to what is known about accounting covenants in private debt, little empirical evidence on the role of accounting covenants in public debt exists. Diffuse ownership, arm’s length monitoring, and collective action problems are unique to the public debt setting and raise the question of whether these covenants serve their intended role. As such, this study investigates whether including covenants reliant upon accounting inputs influences borrowers’ actions to prevent adverse credit events. Accounting covenants in the public debt setting provide firms with a disciplining mechanism to renegotiate ahead of costly technical default — a stark contrast to the ex-post renegotiation “trip wire” role covenants play in private debt. In particular, the results show that including accounting covenants in public debt is associated with an increased probability of ex-ante renegotiation, that is, negotiation through consent solicitations ahead of covenant violation. This ex-ante renegotiation, in turn, is associated with decreased adverse credit events. Cross-sectional results support these findings as the ex-ante renegotiation role of accounting covenants varies with bondholders’ and trustees’ monitoring ability.

Corporate Loan Securitization and the Standardization of Financial Covenants

We examine whether syndicated loans securitized through Collateralized Loan Obligations (CLOs) have more standardized financial covenants. We proxy for the standardization of covenants using the textual similarity of their contractual definitions. We find that securitized loans are associated with higher covenant standardization than non-securitized institutional loans. In addition, we show that CLOs with more diverse or frequently rebalanced portfolios are more likely to purchase loans with standardized covenants, potentially because standardization alleviates information processing costs related to loan monitoring and screening. We also document that covenant standardization is associated with greater loan and CLO note rating agreement between credit rating agencies, further supporting the relation between lower information costs and covenant standardization. Overall, our study provides evidence that loan securitization is related to the design of standardized financial covenants.

Soft Information in Loan Agreements

In this study, we seek to understand whether soft information conveyed by contracting language found in private loan agreements is informative regarding borrower risk. We proxy for credit-risk-relevant soft information using Loughran and McDonald’s uncertainty measure. We first examine initial contract terms and find that, incremental to traditional summary measures of credit risk, increased contractual uncertainty is associated with higher initial loan spreads and a greater likelihood of using dynamic and performance-pricing covenants. We then turn to examine realized credit risk over the life of the loan and find that increased uncertainty is associated with a higher likelihood of future loan downgrades and loan amendments. We corroborate our results on the risk relevance of soft information by showing that the bid-ask spreads of loans trading on the secondary loan market are increasing in uncertainty. Overall, the evidence we provide is consistent with embedded linguistic cues in loan agreements publicly revealing the credit risk assessments of privately informed lenders.