Bond Covenants

A bond covenant is a legally binding clause in a bond’s contract (the indenture) that either requires the issuer to take specific actions or restricts the issuer from certain activities. Covenants protect bondholders by reducing actions that could impair the issuer’s ability to repay debt, and they protect issuers by clarifying expectations and limits.

Key takeaways

• Covenants are enforceable terms in a bond indenture that require or prohibit certain actions by the issuer.
• Breaching a covenant is typically a technical default and can lead to penalties such as rating downgrades, acceleration of debt, or other legal remedies.
• Affirmative (positive) covenants require the issuer to do something (e.g., provide audited financials).
• Negative (restrictive) covenants prevent the issuer from doing something (e.g., taking on additional debt beyond a set limit).

How covenants work

Covenants are included in the bond indenture and remain in effect for the life of the bond. Common covenant provisions include:
* Limits on additional borrowing to prevent overleveraging.
Requirements to deliver periodic audited financial statements.
Restrictions on capital expenditures or asset sales.

If an issuer violates a covenant, the bond is in technical default. Consequences may include:
* Credit rating downgrades, which can increase borrowing costs.
Creditors declaring an event of default and demanding immediate repayment (sometimes after a grace period).
Legal action or restructuring negotiations.

Credit-rating agencies evaluate covenant quality; for example, some agencies use a scale indicating stronger or weaker covenant protection. Weak covenant protections can make bonds riskier for investors.

Types of bond covenants

Affirmative (positive) covenants

Affirmative covenants require the issuer to perform specific actions. Typical examples:
* Maintain adequate insurance.
Furnish audited financial statements to bondholders.
Comply with applicable laws and maintain proper accounting records.

Violation usually constitutes default. Some issues include cure or grace periods; if the breach is not remedied, creditors may accelerate repayment.

Negative (restrictive) covenants

Negative covenants limit issuer actions that could harm creditors’ interests. Common forms include financial-ratio tests, such as:
* Maximum total-debt-to-earnings ratios to prevent excessive leverage.
* Minimum interest-coverage ratios (e.g., EBIT divided by interest expense) to ensure the issuer generates enough earnings to pay interest.

These restrictions help keep the issuer’s financial profile within agreed bounds during the life of the bond.

Example

A municipal bond issuance may include a covenant allowing the issuer to levy taxes at a specified rate or level to ensure debt service coverage. For instance, a debenture could require annual tax levies sufficient to cover at least 105% of required debt service and state that tax revenues provide many times coverage of the maximum annual debt service (MADS). Such provisions give investors assurance that revenues or taxing authority exist to meet obligations.

Practical considerations for investors and issuers

• Investors should read the indenture to understand covenant protections and any limitations or exceptions. Stronger covenants reduce risk but can be relaxed in competitive markets.
• Issuers balance covenant strictness with market demand; tighter covenants may lower borrowing costs but restrict operational flexibility.
• Monitor covenant compliance through periodic financial disclosures and watch for credit-rating changes that may reflect covenant quality or breaches.

Covenants are a core element of bond contracts: they define the rights and responsibilities that influence credit risk, pricing, and the remedies available if financial conditions deteriorate.