Covenant Strictness Measures

Covenants are crucial components of loan agreements, designed to protect lenders by imposing various restrictions and obligations on borrowers. Despite extensive empirical research on covenant strictness, a universally accepted measure of covenant strictness remains elusive. Existing metrics tend to include only a limited selection of covenants from the comprehensive contract. This study utilizes loan-level credit risk data to evaluate and rank the effectiveness of several widely used covenant strictness measures. Credit risk at the loan level is assessed through two primary methods: the difference between issue ratings and issuer ratings, and the loan credit spread while controlling for fixed effects at the firm level. This approach allows for a more nuanced comparison and provides insights into which measures most accurately reflect covenant strictness and its impact on credit risk. The findings aim to contribute to a better understanding of covenant effectiveness, offering potential improvements for future loan contract structuring and risk assessment practices.