Debt financing comes with all sorts of stipulations. This is especially true for bond issuers seeking to raise money. What attracts investors to bonds is their par value and coupon rate; however, the governing details of each bond are also important. At the core of any bond offering, the bond covenants spell out the most important stipulations. For example, the ones that could trigger default if not adhered to.
A bond covenant can contain any number of restrictive or affirmative criteria. Covenants protect bondholders from risks they might not have considered when they decided to invest in certain bonds. By placing covenants in the bond agreement, underwriters protect bondholders from future risk, while giving the company guardrails to follow as it seeks to maintain its creditworthiness.
Bond covenants are an important part of bond agreements. Here’s a closer look at how they work, and why they’re important for both investors and issuers.
The Purpose of a Bond Covenant
The bottom-line purpose of a bond covenant is to protect both bond issuers and investors. By restricting or encouraging certain activities, underwriters create trust that keeps both parties true to the purpose of the bond agreement. Investors have confidence that the company will act with integrity and maintain interest payments, while issuers keep themselves solvent and reliable over the life of the bond.
Covenants live in the indenture: a document within the bond agreement that’s underwritten by an investment bank. Covenants come in two primary variations: restrictive covenants and affirmative covenants.
Restrictive (Negative) Bond Covenants
Restrictive bond covenants, sometimes called “negative clauses”, stipulate terms and conditions that prohibit the issuer from certain things. They’re designed to protect the issuer from a creditworthiness reduction that might affect the integrity of a bond.
For example, a restrictive covenant might stipulate that the company needs to maintain a certain debt-to-earnings ratio. This means the company can’t take on any more debt unless it also increases its earnings, thereby protecting the financial stability and creditworthiness of the business.
Other common restrictive bond covenants include interest coverage ratios, indebtedness limitations, lien limitations, capital expenditure limitations and others, depending on the nature of the bond.
Affirmative (Positive) Bond Covenants
Affirmative covenants are positive and stipulate that the issuer perform certain actions that continue to ensure the company’s trustworthiness and creditworthiness. They’re also meant to protect the integrity of the bond once it’s in the hands of investors.
Here again, there are many examples of affirmative bond covenants. Maintenance of financial statements, insurance policy renewals, general legal compliance are all good examples. Generally, these agreements are easier to maintain, since they’re usually things the issuer is already doing.
Many affirmative bond covenants come with grace periods that allow for wiggle room. For example, if insurance is a stipulation and coverage lapses, the issuer might have 21 days to renew before it faces default.
What Happens if the Issuer Breaks Covenant?
In the event a bond issuer breaks covenant, they automatically default on the bond. Creditors then have the right to demand immediate repayment of the bond principle, as well as any accrued interest. Bond covenants are legally binding, and creditor recourse is often spelled out as part of the covenant agreement.
Accompanying this technical default is usually a credit rating reduction. A reduced credit rating could dissuade lenders and investors from seeking out bonds from the offending organization in the future. This, in turn, could force companies to issue bonds at a higher-than-average interest rate as they seek to attract buyers with a larger appetite for risk.
While companies have their own credit ratings, covenants also receive ratings. For instance, Moody’s rates bond covenant quality on a scale of 1 to 5. The higher the number, the worse the rating. A covenant rating of 1 means the company consistently adheres to all stipulations outlined within the bond agreement. A covenant rating of 5 means the company is in defiance of the stipulations and at risk of technical default.
The bond covenant rating is a signal to investors about the reliability of the company and the integrity of the bond. Bonds with downgraded covenant ratings become less desirable and may fall out of favor, trading for a discount.
Bonds Without Covenants?
While an important part of any bond agreement, there are many bonds that actually lack covenants. Many companies forgo any covenants whatsoever as a way to give the organization freedom to continue operating. As a result, borrowers have no real recourse to keep the company in-check if it starts to operate outside the general scope of normal operations.
Bonds without covenants represent a slightly increased level of risk for investors. If the issuer damages its credit rating and the market value of the bond drops, for example, investors can’t evoke any covenant clauses to declare default. They’re simply left holding the bond until maturity (or recall).
Keep Covenants in Mind Before Investing
Bond investors need to look past the par value and coupon rate of bonds, to take heed of the issuer and any covenants they’re bound to. Bonds with strong covenants can mitigate some of the risk of delving into a fixed-income investment if the company were to falter on its responsibilities. Restrictive and affirmative covenants go a long way in providing peace of mind for investors that a company will continue to act in a responsible manner. At least, for the term of the bond.