What Are Bond Covenants?
A bond covenant is a legally binding term of agreement between a bond issuer and a bondholder, crafted to safeguard the interests of both parties.
Negative or restrictive covenants impose restrictions on specific issuer activities, while positive or affirmative covenants necessitate the issuer to comply with specific conditions.
Key Takeaways
- A bond covenant delineates allowable and forbidden activities for a bond issuer.
- Covenants are mandatory clauses that, if violated, trigger compensatory or legal action.
- Affirmative (positive) covenants obligate issuers to engage in certain activities or meet particular benchmarks.
- Restrictive (negative) covenants prevent a company or issuer from taking certain actions.
Why Bond Covenants Matter
Lenders often impose covenants to shield themselves from borrowers’ potential financial missteps. Covenants are embedded within the bond’s documentation, applicable to both corporate and government bonds. The bond’s indenture specifies both positive and negative covenants enforceable until the bond’s maturity. These covenants may restrict the issuer from accumulating additional debt, require providing audited financial statements to bondholders, and limit new capital investments.
Violation of a bond covenant is termed technical default. A breach commonly results in a downgraded bond rating, making it less appealing to investors and escalating the issuer’s borrowing costs.
For instance, Moody’s rates bond covenant quality from 1 to 5, with five indicating frequent violations. In Q4 2020, Moody’s reported a record high weak bond covenants quality score of 4.47, reflecting the terms easier on borrowers amid market recovery.
Affirmative Bond Covenants
An affirmative or positive covenant obliges the issuer to perform specific actions. Examples include maintaining adequate insurance, providing audited financial statements, adhering to laws, and maintaining proper accounting books and credit ratings. Breaching an affirmative covenant can result in default, prompting creditors to demand repayment of the principal and any accrued interest if uncorrected during a grace period.
Negative Bond Covenants
Negative, or restrictive, bond covenants restrict issuers from actions that could impair their credit standing and debt repayment ability. Common negative covenants enforce maintaining financial ratios such as the total debt to earnings ratio, ensuring the company does not exceed manageable debt levels.
One prevalent covenant is the interest coverage ratio—stipulating EBITDA be greater than interest payments by a multiple, confirming sufficient earnings to cover interest expenses.
Real-World Example
On June 23, 2016, Hennepin County, Minnesota issued a bond to finance part of an ambulatory outpatient specialty center at the county’s medical center. The bond achieved a AAA rating, backed by the county’s comprehensive credit and unlimited taxing authority. The bond’s covenants mandated the county to levy sufficient taxes to cover 105% of debt service annually and ensured potent debt service coverage, reinforcing strong investor confidence.
Conclusion
Understanding bond covenants enriches your investment insights, providing clarity on the issuers’ commitments, financial ethics, and the protective frameworks within the bond market. Keeping abreast of these terms can greatly influence your investment choices and expectations.
Related Terms: covenants, affirmative covenants, restrictive covenants, technical default, bond rating, interest coverage ratio
