Bond covenant definition

What is a Bond Covenant?

A bond covenant is a legal agreement between the issuer and purchaser of bonds. In it, the issuer commits to avoid certain actions that might reduce its financial condition over the term of the associated bonds. The intent of this agreement is to protect the financial interests of the bond holders, thereby increasing the likelihood that they will be paid back in full as of the maturity date of the bonds. Bond covenants are fully enforceable over the term of a bond, which may span many years.

Bond issuers prefer not to be restricted by covenants, and so will try to avoid them to the greatest extent possible. This is not difficult for the larger and more financially stable bond issuers, and especially in a hot bond market where investors are willing to take more risk in order to participate in an issuance. However, this is not the case for smaller and more financially troubled issuers, who may be forced to accept a number of covenants; this is especially likely to be the case in a slow bond market where these issuers are having trouble raising money.

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Types of Bond Covenants

There are two types of bond covenants, each with differing characteristics. They are as follows:

  • Restrictive covenant. Under a restrictive covenant, the issuer is forbidden from engaging in certain activities, such as issuing dividends to its shareholders, or taking on additional debt. Another example is the presence of a performance ratio, such as a requirement not to exceed a 1:1 debt to equity ratio. Ratio-based covenants force an issuer to maintain a conservative financial structure.

  • Affirmative covenant. Under an affirmative covenant, the issuer promises to meet certain requirements, such as paying into a bond repayment fund at certain intervals, issuing audited financial statements, and complying with all applicable laws.

Bond Technical Defaults

When a restrictive covenant is breached by the bond issuer, it is considered a technical default. Credit rating agencies watch for these technical defaults, and may downgrade their ratings of a bond when one occurs. When a bond’s rating declines, there will likely be a sell-off on the secondary market, resulting in a decline in the bond’s price. This also means that the issuer will probably have to accept a higher interest rate if it were to issue any additional bonds to the investment community.

When an affirmative covenant is breached by the bond issuer, it is considered an outright default. In this case, bond holders can demand to be paid all principal and accrued interest at once, or following a short grace period.

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