Covenants are the terms of offering that aim to protect both investor and issuer interests
The issuer and a trustee enter into a legally binding agreement called a trust indenture. The indenture outlines all financial covenants, the terms of agreement (covenants) that protect all parties’ interests until the maturity of the bond or the specified duration of the covenant. Violation of covenants will put the issuer in technical default, triggering remedies that protect investor interests (e.g. foreclosure, increased coupon rate). Issuers should be cautious when stipulating covenants, as they may hinder their ability to effectively utilize proceeds of the new issue and restrict business operations.
Negative or restrictive covenants limit certain issuer activities. Negative covenants may restrict financing activities, payouts, investment activities and asset sales. Negative covenants include:
Positive, or affirmative, covenants require issuers to remain in compliance with the agreement by meeting specific requirements and completing certain actions. These covenants include carrying insurance policies, maintaining certain performance standards, and providing financial statements. Positive or affirmative covenants include:
Financial covenants require issuers to maintain certain financial ratios. They are performance metrics covenants that provide remedies if the issuer’s financial health deteriorates. There are two types of financial covenants:
Financial covenants may include:
Other common covenants include:
Generally, investment-grade issuers have few and simple covenants because of their size and relatively lower risk. High-yield issuers, on the other hand, typically agree to complex indentures with an extensive list of covenants due to their relatively higher risk.