Debt Covenants BondDefined with Examples & More

Written By:
Lisa Borga

What is a Bond Covenant?

In some cases, bonds may be issued with a debt covenant, which is a legally binding agreement between the issuer and the holder.

These covenants apply certain restrictions on the activities of the issuer in order to ensure that they are capable of repairing the debt.

These take the form of positive covenants, which require the borrower to perform certain activities or meet certain requirements, and negative covenants, which prohibit the issuer from performing certain activities.

A bond covenant can have benefits for both issuers and holders of bonds.

Issuers can benefit from reduced interest rates due to the reduced risk of defaulting on the loan, and holders benefit from a greater guarantee that they will receive payments.

Bond Covenants Explained

Bond covenants are a form of debt covenant that may be included in an agreement between bond issuers and bondholders.

These agreements are intended to place restrictions on a bond issuer which could prevent them from being capable of meeting their obligations to repay the debt.

Bond covenants are included in a bond’s legal documentation or indenture and exist in both government and corporate bonds.

These agreements are enforceable through the entirety of a bond’s life until it reaches maturity.

Bond covenants often include provisions such as restricting the issuer from taking on additional debts, requiring the issuance of audited financial statements annually, maintaining casualty insurance, or restricting the extent of cash dividends.

Violation of the terms of a bond covenant is considered to be a technical default.

The consequences of such a violation may vary significantly based upon the terms of the bond indenture as well as the circumstances of the violation.

A breach of a bond covenant may simply be waived by the bondholders, or it may result in an increase in the bond’s interest rate, an increase in the amount that must be put up as capital, or any other potential consequences.

One of the most common results of a violation of a bond covenant is a downgrade in the bond rating.

This will make the bond a less desirable option for investors reducing the company’s ability to acquire future investments and likely increasing the bond issuer’s cost of borrowing.

In certain cases, a violation of a bond covenant may result in the bondholder announcing a default and demanding immediate repayment.

Generally, this will only occur if a bond issuer does not correct a violation of a bond covenant after a certain period of time.

Positive Bond Covenants

Positive bond covenants, also known as affirmative covenants, require the bond issuer to take certain actions.

In other words, these are covenants stating what a bond issuer must do.

Common examples of this include achieving certain financial benchmarks, providing audited financial statements annually, keeping accounting practices in line with Generally Accepted Accounting Principles, maintaining certain levels of insurance, and regularly maintaining specified capital assets.

Negative Bond Covenants

Negative bond covenants, also known as restrictive bond covenants, prohibit bond issuers from taking certain actions.

These agreements thus concern what a bond issuer cannot do.

This commonly may include prohibiting management from paying dividends above a certain threshold, taking on more debt, entering certain agreements, or selling particular assets.

A common example of a type of negative covenant is one requiring the issuer to meet a certain interest coverage ratio which requires the bond issuer to ensure its earnings before interest and taxes are above a certain proportion of the bond’s interest payments.

This ensures that the bond issuers produce enough earnings to meet their obligations to make interest payments.

Why Are Bond Covenants Important?

Bond covenants are important for both borrowers and bondholders alike.

Though bondholders do not want to create prohibitive requirements that burden the bond issuer and prevent it from being able to act in its best interests, they want to be sure that they will be able to get their money back.

As a result, certain terms and conditions included with the bond can help ensure that the issuer does not take actions that may prevent them from making payments.

For bond issuers, bond covenants are important because they can help them to mitigate their costs of borrowing.

When a bond issuer includes a covenant as part of the bond indenture, they can reassure potential investors that they will likely be able to make interest payments and repay the full amount at maturity.

As a result, they can often provide a lower interest rate than they would be able to without such a debt covenant.

Example of Bond Covenants

As an example of bond covenants in practice, consider a manufacturing company that wants to finance the construction of a new production facility.

The company chooses to issue bonds to help finance the facility and chooses to include a bond covenant in order to reduce its interest rate and, therefore, its costs of borrowing.

The manufacturing company stipulates in the covenant that it will maintain a certain level of earnings before interest and taxes, provide audited financial statements to investors annually, and will not take on any additional loans until the bond reaches maturity.

In the event that the bond issuer fails to meet these stipulations, the company agrees that the interest payments to bondholders will rise by 2%, and penalty payments of $2,000 will be issued.

In the event that these issues are not corrected in a grace period of 30 days, investors may demand immediate repayment of the bond’s face (par) value.

By doing these things, investors are able to see that there is a greater guarantee that they will receive their regular interest payments as well as the bond’s face value upon maturity.

Because of this, a greater number of investors are willing to accept the lower interest rates that the manufacturer’s bonds offer.

Key Takeaways

• Bond covenants are formal agreements between a bondholder and its issuer that set out certain requirements that the issuer must meet or activities that it is prohibited from performing.
• Bond covenants are contractual agreements that, if breached, may result in significant legal consequences.
• Positive bond covenants require the issuer to perform certain activities or meet certain benchmarks, such as reaching certain financial ratios or issuing audited financial statements annually.
• Negative bond covenants prohibit a bond issuer from performing certain activities such as withdrawing additional loans or paying cash dividends greater than a certain extent.