High-Yield Debt Covenants and Their Real Effects

Abstract

High-yield debt, including leveraged loans, typically features incurrence or ′′cov-lite'' financial covenants. Unlike traditional maintenance covenants, incurrence covenants preserve equity control rights but impose specific contractual restrictions on the borrower once certain financial thresholds are crossed. Contrary to the prevailing view that incurrence covenants have limited practical impact, we document a substantial decline in investment when these covenants are triggered. During economic downturns, these provisions can become binding well before default or bankruptcy. Our findings reveal a novel channel through which economic shocks propagate, driven by incurrence-based contractual restrictions that are widespread in the highly leveraged corporate sector.