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Covenants mitigate agency frictions but can trigger asset sales at fire sale prices.
I demonstrate covenant-driven fire sales and trace their real effects. Following a
large negative oil-price shock, collateralized loan obligations exposed to oil-and-gas
(O&G) firms approach their covenant thresholds and sell non-O&G loans, exerting
price-pressure on non-O&G bonds and loans in primary and secondary markets. Affected
non-O&G borrowers experience declines in financing, investment, R&D, and employment.
Instrumenting CLO net loan sales with lenders’ O&G exposure, a one-percentage-point
increase reduces firm investment by 0.08 percentage-points, 5% of mean investment.
Covenant-induced liquidations can thus generate credit crunches via capital-market
contagion.
