Corporate Bonds and the Importance of Covenants

In every corporate bond or other security contract, there will always be clauses, covenants, as well as subsidiary agreements included that are intended as legal and economical safeguards for the loan agreement the two parties are entering into, particularly established for the protection of the lenders invested funds. These covenants are secondary obligations above and beyond repayment and interest that are typically placed on the issuer of the corporate bond. It is highly important that an investor, private or institutional, makes him or herself familiar with the specific covenant clauses when investing in this type of fixed income security. These clauses are typically stipulated to predefine what breach of such contracts on the part of the borrower/ issuer would look like as well as what the creditor would be specifically granted to compensate for such a breach. There are typically two distinct types of covenants, including financial covenants (these type of safeguards pertain to predefined financial metrics, figures, and/or ratios) as well as non-financial covenants (these are tied to specific actions, what an issuer can and cannot do, instead of numbers and finances).

The most common types of covenants found in corporate bond terms and conditions include, amongst others, pari passu clauses and negative pledges, changes of control, dividend restrictions and payout restrictions, and defaults on payment and cross-default clauses. Without going into great detail, in the following, we briefly examine what some of the common covenant clauses encompass.

The pari passu clause - This means that during the duration of the unsecured debt, payments for any future unsecured securities cannot take priority of this existing debt. The issuer, in this clause, is expressly obliged to make such pro rata payments on the existing debt firs

The negative pledge - When a negative pledge is made, the issuer agrees not to grant any securities to future investors during the term of an unsecured corporate bond. An exception to this can be made if the issuer can produce a security equal to the value of the unsecured bond to the benefit of the creditor as well.

A so-called change of control - This describes a situation where the economic or legal authority/ ownership of an issuer occurs. For example, where a new party acquires more than 50% of the shares.

Pay-out restrictions and dividend restrictions - There may be restrictions on the pay-outs that an issuer can make over the life of the bond as well. Predefined amounts may be specified on office balance sheets; ratios must be preserved (for example, the capital ratio may be required to remain above a certain percentage), or other similar restrictions. Additionally, there may be other restrictions on what amount the payouts may not exceed. For example, they may be limited to a total of half the issuer’s annual profits.

The cross-default clause - If included, this clause obliges the issuer to comply with any obligations that may arise from third party contracts involved with the security. It would, in essence, require affiliates and subsidiaries of the issuer to comply to with obligations of the contract as if they were the issuer.

Purpose and Legal Consequences

There are typical clauses included in a loan meant to safeguard the lender, in the event of an adverse financial developments for the debtor/ issuer of a corporate bond security. These act as early warnings of an issuer perhaps being unable to make their financial obligations. Such clauses usually stipulate that in the event the issuer breaches the agreement because of such negative financial developments, the lender has the right to ask for the terms of the loan agreement to be amended to either add more securities or adjust the interest rate to compensate for the additional risk that has developed. In some circumstances, such clauses include provisions for termination of the bond if the lender/ creditor so desires.

The Bottom Line

Without any doubt, it is paramount that private or institutional investors are well acquainted with any covenant clauses that subsist in the corporate bond agreement to be aware of if and when certain activities will be carried out or to the contrary will not be carried out. These contractually fixed secondary obligations and binding guarantees on the part of borrower/ corporate bond issuer can be of high significance to the creditors if stipulated clauses are breached by the issuer during the term, this circumstance then triggers the introduction of a specific, predefined event. In the possible event of a borrower defaulting on obligations, such as coupon payments, lenders/ investors may or may not be protected to a certain extent. As above-described, there are two types of covenants, financial and non-financial covenants. Clearly, in the corporate bond universe, most of the covenant agreements relate to terms in the financial contracting.