Credit risk identification in the leveraged loan market using mediation analysis

In recent years, the leveraged loan market has experienced considerable growth, with the covenant lite loan being the predominant agreement. The goal of this research is to assess whether the covenant-lite agreement reduces or increases the probability of default. Using an original sample of 2,280 European leveraged loans, we propose a new approach using mediation analysis. This approach allows us to better understand the role of such agreements and to decompose the effect of balance sheet indicators on a default event into direct and indirect effects, the latter mediated by the covenant-lite agreement. Results show that the covenant-lite agreement is granted to less risky loans. In turn, this agreement plays a role in making a default event less likely, giving rise to a significant indirect effect.