Premium
Do Tighter Loan Covenants Signal Improved Future Corporate Results? The Case of Performance Pricing Covenants
Author(s) -
Beyhaghi Mehdi,
Panyagometh Kamphol,
Gottesman Aron A.,
Roberts Gordon S.
Publication year - 2016
Publication title -
financial management
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.647
H-Index - 68
eISSN - 1755-053X
pISSN - 0046-3892
DOI - 10.1111/fima.12159
Subject(s) - loan , business , covenant , information asymmetry , agency cost , bond , monetary economics , financial system , finance , economics , corporate governance , philosophy , theology , shareholder
Covenants in corporate bonds and loan agreements mitigate agency conflicts between borrowers and lenders and may provide a signal of borrower quality to help resolve information asymmetry. Performance pricing covenants in bank loans specify automatic adjustments to loan spreads based on borrowers’ subsequent performance. Our covenant signaling framework views interest‐decreasing performance pricing as a tight covenant associated with borrowers’ private information on improved future performance accompanied by reduced credit risk. This positive signal is associated with larger positive loan announcement returns and greater improvements in future borrower performance. Further, in addition to signaling value, we find that the spread impact of this class of covenant also depends on its option value and reduction in transaction costs.