Covenant-lite agreement and credit risk: A key relationship in the leveraged loan market

• Published in: Research in international business and finance 2024-06, Vol.70 (Part B), p.102377, Article 102377
• Main Authors: De Novellis, G., Musile Tanzi, P., Stanghellini, E.
• Format: Article
• Language: English
• Subjects: Covenant-lite agreement; Credit risk; Leveraged loans; Mediation analysis; Syndicated loans
• ISSN: 0275-5319; 1878-3384; 1878-3384
• DOI: 10.1016/j.ribaf.2024.102377

In recent years, the leveraged loan market has experienced considerable growth, with the covenant-lite loan being the predominant agreement. The goal of this research is to assess whether the covenant-lite type reduces or increases the probability of default. Mediation analysis allows us to decompose the effect of balance sheet indicators on a default event into direct and indirect effects, the latter mediated by the covenant-lite. Results show that the covenant-lite is granted to borrowers with a greater profitability. In turn, all other conditions being equal, this agreement plays a role in making a default event less likely, giving rise to a significant indirect effect. •The probability of receiving the covenant-lite agreement decreases for loans with a fragile profile.•The covenant-lite agreement reduces the probability of default.•A higher ROA not only directly decreases the probability of default but also increases the probability of obtaining a covenant-lite, which in turn decreases the probability of defaulting.•The use of mediation analysis to identify the probability of default lays the foundation for an alternative to previous approaches used in this field. [Display omitted]