Soft Information in Loan Agreements

In this study, we seek to understand whether soft information conveyed by contracting language found in private loan agreements is informative regarding borrower risk. We proxy for credit-risk-relevant soft information using Loughran and McDonald's uncertainty measure. We first examine initial contract terms and find that, incremental to traditional summary measures of credit risk, increased contractual uncertainty is associated with higher initial loan spreads and a greater likelihood of using dynamic and performance-pricing covenants. We then turn to examine realized credit risk over the life of the loan and find that increased uncertainty is associated with a higher likelihood of future loan downgrades and loan amendments. We corroborate our results on the risk relevance of soft information by showing that the bid-ask spreads of loans trading on the secondary loan market are increasing in uncertainty. Overall, the evidence we provide is consistent with embedded linguistic cues in loan agreements publicly revealing the credit risk assessments of privately informed lenders.