The Screening Role of Covenant Heterogeneity

We investigate whether the mix of financial covenants in debt contracts allows lenders to screen borrowers based on their private information about their future risk-taking intentions. Consistent with adverse selection theories, we predict and find that borrowers with greater risk-taking intentions prefer covenants that are less dependent on their performance, while safer borrowers prefer performance-based covenants. Further tests show that lenders use these contrasting preferences to screen borrowers, especially when their screening needs intensify. This screening through covenant mix: (i) allows lenders to design more efficient contracts with spreads that better anticipate borrowers’ future repayment abilities; and (ii) is at least as informative as and provides information that is incremental to other common screening mechanisms, such as loan maturity or collateral. By highlighting the use of heterogeneity in covenant mix to mitigate pre-contractual information asymmetry with respect to borrowers’ risk-taking intentions, our study answers recent calls to further explain heterogeneity in debt covenants and how they improve debt contract efficiency.