Bond Covenants
A bond is a loan made to an entity that the investors buy hoping to get good returns on their money over a period of time. A covenant is a promise in an indenture or any other legal debt agreement which states that certain activities will be carried out or not, or certain thresholds will be met.
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What are Bond Covenants?
There is a legal agreement between the bondholder and bond issuer which is called an Indenture. The indenture consists of items called Bond covenants which specify what the bond issuer may or may not do during the life of the bond to provide the investors some assurance, whether it is issued by a company or the government. This is a legally binding contract between the issuing firm and the creditors. It lays down the process of all the contractual responsibilities and obligations of each party. The issuer is bound by these covenants till the maturity or end of the term of the bond.
How do they work?
Bond covenants might include restrictions that may prevent the bond issuer from taking additional debt. If an issuer violates a bond covenant it is considered to be a technical default. A common penalty applicable is the downgrading of the bonds rating which then becomes less attractive to the investors.
Example:
A company ABC issues a bond worth $12,000,000 which an investor was interested in. The investor does a thorough evaluation of the company and finds out that in the last financial year the company had sold many of its assets in order to pay back a long-term loan. The investor was very keen on purchasing the bond so he added a bond covenant in the indenture saying that the company needs to maintain a minimum tangible net worth of $1,000,000 throughout the term of the bond. this is an example of a positive covenant as the borrower has to maintain a certain aspect of its business rather than restrictions in the operation of the business.
One of the negative covenants in the bond indenture is that the bond issuer cannot issue more bonds until the previous bonds have matured. Also, in some indentures, the issuer is required to maintain a debt to equity ratio of not more than one.
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Types of covenants:
- Positive covenants
- It is also called affirmative covenants which prescribes the condition of maintaining the operational well-being and stability of the borrower’s business.
- This could involve retaining or providing financial statements with certain standards of financial performance.
- When there is a breach of positive bond covenants, the lender gains certain control rights like calling the entire loan amount, charging a higher coupon rate, or seizing the assets or collateral.
- Negative covenants
- Also known as a restrictive covenant which restricts one party from carrying out certain actions. They are legal but some provisions restrict the borrowers in performing day to day business activities.
- This could include, for example, maintaining a certain level or a leverage ratio, which can limit the issuer’s financial wisdom.
- Negative covenants are of three types namely non-competent agreement, non-solicitation agreement, and non-disclosure agreement.
Importance:
- They form the legal rights of bondholders to protect and ensure that the company’s cash flow is targeted towards payments of the coupons and repayment of the bond.
- Covenants are related to the market cycle thus the trend of the covenants can pinpoint the stage on the cycle.
- It is important for the investors to know how the covenants are changing which are designed to protect against risky behavior and thus the risk they are taking can be known.
Based on their financial stability, covenants may therefore reward the investors or punish the borrowers. There may come a time when the covenants are in the spotlight or a company is in danger due to breach of these covenants so the investors who understand their contract with the covenants properly will act proactively.
Author -Sanjana Rau
About the author- Started my journey of self even when the odds were against me, keen observation, a cool temper, and sports worked the best for me.
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