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Transitory and Permanent Cash Flow Shocks in Debt Contract Design

We examine how lenders design contracts when borrowers are exposed to volatile transitory or permanent cash flow shocks. We find that volatile transitory shocks are associated with fewer liquidity covenants, indicating financial flexibility that can enable firms to survive temporary shocks. The opposite is true for volatile permanent shocks, suggesting that borrowers’ economic fundamentals are important credit risk factors. Subsequent tests show that borrowers exposed to volatile transitory (permanent) shocks face less (more) severe consequences after covenant violations. We also find that lenders design contracts to control for agency risk, especially when borrowers are prone to gamble by delaying default.