Companies issue bonds to finance their operations. Most companies could borrow the money from a bank, but they view this as a more restrictive and expensive alternative than selling the debt on the open market through a bond issue.

Key Takeaways

  • Banks tend to place restrictions on borrowers that limit their business activities.
  • For the banks, it's a precaution against risk. For companies, it can be a barrier to action.
  • The bond market places no comparable restrictions on borrowers.

In fact, the costs involved in borrowing directly from banks are prohibitive to many companies. In the world of corporate finance, many chief financial officers (CFOs) view banks as lenders of last resort because of the restrictive debt covenants that they place on direct corporate loans.

How Covenants Work

Covenants are rules placed on debt that are designed to stabilize corporate performance and reduce the risks to which a bank is exposed when it gives a large loan to a company. These restrictive covenants protect the bank's interests. They're written by securities lawyers and are based on what analysts have determined to be risks to the company's performance.

Here are a few examples of restrictive covenants that have been placed on companies:

  • They can't acquire any more debt until the bank loan is completely paid off
  • They can't issue any new share offerings until the bank loan is paid off
  • They can't acquire any other companies until the bank loan is paid off

From the bank's viewpoint, these are reasonable precautions. They have evaluated the company's current financial condition, including its debt level. If that changes overnight, the risk evaluation is no longer valid.

Relatively speaking, these are straightforward, unrestrictive covenants. But debt covenants can be much more convoluted and carefully tailored to the company's unique business risks.

Some of the more forbidding covenants may state that the interest rate on the debt will increase substantially if the chief executive officer (CEO) quits or if earnings per share drop within a given period of time.

There are also "positive" as opposed to "negative" covenant restrictions. The bank may require that the company maintain certain levels in financial ratios or maintain its facilities in good working condition.

The Risks to Companies

Thus, covenants are a way for banks to mitigate the risk of holding debt, but for the companies that borrow from them, they can add new risks.

Consider, for instance, a covenant that automatically increases the interest rate if earnings slump. The company's business challenges have just doubled.

Interest rates on corporate loans can be hiked, just like those on consumer credit.

Banks place greater restrictions on how a company can use the loan and are more concerned about debt repayment than bondholders. Bond markets tend to be more lenient than banks and are often seen as easier to deal with. They leave it to the rating agencies to grade the bonds and make their decisions accordingly.

As a result, companies are more likely to finance operations by issuing bonds than by borrowing from a bank.