The Technical Default Spread

Emilio Bisetti, Kai Li and Jun Yu

The Review of Financial Studies, 2024, vol. 37, issue 11, 3386-3430

Abstract: We study the quantitative impact of lender control rights on corporate investment, asset prices, and the aggregate economy. We build a general equilibrium model in which the breaching of a loan covenant (technical default) entails a switch in investment control rights from borrowers to lenders. Lenders optimally choose low-risk projects, thus mitigating borrowers’ risk-taking incentives and lowering the cost of equity. This mechanism generates strong macroeconomic effects and mitigates the financial accelerator. Consistent with our model, proximity to technical default in the data is associated with 4.12% lower returns and lower exposure to systematic risk.

Keywords: E2; E3; G12 (search for similar items in EconPapers)
Date: 2024
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