A:

Bond covenants can limit the amount of leases a company can have because leasing contracts are a form of debt. Taking on more debt is a form of risk in the eyes of the bondholders, and therefore bond covenants typically restrict the amount of debt a company can take on. This restriction can sometimes come in the form of a maximum debt-to-equity ratio that the company is not allowed to surpass. If the company's debt-to-equity ratio exceeds the agreed-upon level this could constitute a breach of the contract and the bondholder has the right to seek legal remedy.

Occasionally, companies may try to hide leases off their balance sheet by claiming them as operating leases instead of capital leases, which allows them to circumvent bond ratio covenants. The lease would be treated as a capital lease if one of the following criteria is met: there is a transfer of ownership; there is a bargain purchase option in the lease; the lease life is more than 75% of the economic life of the asset; or the present value of the lease payments are more than 90% of its cost. To avoid treating the lease as a capital lease, the company may structure the lease so that it does not technically qualify as a capital lease by adjusting the lease life, lease payments or other aspects of the lease. Of course, bondholders are aware of this and often have covenants that will take into account off-balance sheet leases.

Learn more about off balance sheet debt in our article: Uncovering Hidden Debt.

This FAQ was answered by Joe Nguyen.

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