What is an Affirmative Covenant?

An affirmative covenant is a type of promise or contract that requires a party adhere to certain terms. For example, an affirmative bond covenant could provide that an issuer maintain adequate levels of insurance or deliver audited financial statements.

Understanding Affirmative Covenant

Affirmative (or positive) covenants can be compared to restrictive (or negative) covenants, which require a party to cease or avoid doing something, such as selling certain assets. Additional examples of affirmative covenants include obligating the issuer to return the principal of a loan at maturity or maintain its underlying assets or specific collateral, such as real estate or equipment. In bond agreements, both affirmative and restrictive covenants are used to protect the interests of both issuer and bondholder.

Key Takeaways

  • Affirmative covenant refers to the promise or contract to adhere to certain pre-defined terms.
  • Affirmative covenants are essentially protections for investors, if there are problems with the company.
  • In recent times, investors have taken a lax attitude towards affirmative covenants.

Current Environment Surrounding Affirmative Covenants and Leveraged Loans

In September 2017, Bloomberg ran an article about the lack of affirmative (or restrictive) covenants in many new offerings. The term “covenant-lite” has been used to describe several new leveraged loans. Without such protections a a company could potentially rack up a significant amount of debt without regard for performance. The relaxed atmosphere for such terms has created the perception that a loan must be of poor quality if a borrower has to resort to covenants at all. Currently, several lenders do not even require that the issuer meet periodic performance goals (also known as maintenance covenants).

While bets of this nature are safer for larger and more established companies with regular cash flows (like blue chip companies), some investors are concerned over loans to middle-market borrowers. These companies often have earnings before interest, taxes, depreciation, and amortization or EBITDA under $50 million, giving them less wiggle room to recover from a costly error and increase their risk of default.

At the other end of the spectrum are cases like those of J.Crew Group, Inc. Faced with declining sales and impatient lenders in 2017, the clothing retailer created an unregistered subsidiary to hold its intellectual property. The new subsidiary was then used as collateral to secure another loan for the company. As a result of J Crew's move, investors in companies began including a covenant known as the J.Crew blocker, which prevented companies from carrying out such moves in the future.

Example of Affirmative Covenant

In a March 2018 report by Mayer Brown LLP on high yield bonds by German real estate companies, the firm noted that another player, the Luxembourg-based Corestate Capital Holding S.A. (S&P: BB+) joined the group of real estate companies issuing debt. These notes represent a junior portion in firm’s overall capital structure. Unlike traditional high yield bonds, these notes from Corestate Capital will not be callable prior to maturity. At the same time German law stated that they will not contain a full, traditional high yield covenant package. No limitations will be placed on Corestate to restrict distributions from its subsidiaries. In addition, there is no affiliate transactions covenant.