What Is a Covenant?
In legal and financial terminology, a covenant is a promise in an indenture, or any other formal debt agreement, that certain activities will or will not be carried out. Covenants in finance most often relate to terms in a financial contracting, such as a loan document or bond issue stating the limits at which the borrower can further lend.
[Important: Covenants are often put in place by lenders to protect themselves from borrowers defaulting on their obligations due to financial actions detrimental to themselves or the business.]
How Covenants Work
Covenants are most often represented in terms of financial ratios that must be maintained, such as a maximum debt-to-asset ratio or other such ratios. Covenants can cover everything from minimum dividend payments to levels that must be maintained in working capital to key employees remaining with the firm. Once a covenant is broken, the lender typically has the right to call back the obligation from the borrower. Generally, there are two types of covenants included in loan agreements: affirmative covenants and negative covenants.
An affirmative, or positive, covenant is a clause in a loan contract that requires a borrower to perform specific actions. Examples of affirmative covenants include requirements to maintain adequate levels of insurance, to furnish audited financial statements to the lender, compliance with applicable laws, and maintenance of proper accounting books and credit rating, if applicable. A violation of affirmative covenants ordinarily results in outright default. Certain loan contracts may contain clauses that provide a borrower with a grace period to remedy the violation. If not corrected, creditors are entitled to announce default and demand immediate repayment of principal and any accrued interest.
Negative covenants are put in place to make borrowers refrain from certain actions that could result in the deterioration of their credit standing and ability to repay existing debt. The most common forms of negative covenants are financial ratios that a borrower must maintain as of the date of the financial statements. For instance, most loan agreements require a ratio of total debt to a certain measure of earnings not to exceed a maximum amount, which ensures that a company does not burden itself with more debt than it can afford to service. Another common negative covenant is an interest coverage ratio, which says that earnings before interest and taxes (EBIT) must be greater in proportion to interest payments by a certain number of times. The ratio puts a check on a borrower to make sure that he generates enough earnings to afford paying interest.
- Covenants exist in financial contracts, such as bond issues, that set out certain activities that will or will not be carried out.
- Covenants are legally binding clauses, and if breached will trigger compensatory action.
- Covenants that allow are called affirmative while those that restrict are classified as negative covenants.
A bond violation is a breach of the terms of the covenants of a bond. Bond covenants are designed to protect the interests of both parties, where the inclusion of the covenant is in the bond's indenture, which is the binding agreement, contract or document between two or more parties.
When an issuer violates a bond covenant, it is considered to be in technical default. A common penalty for violating a bond covenant is the downgrading of a bond's rating, which could make it less attractive to investors and increase the issuer's borrowing costs. For example, Moody's, one of the major credit rating agencies in the United States, rates a bond's covenant quality on a scale of 1 to 5, with five being the worst. This means that a bond with a covenant rating of five is an indication that covenants are being violated consistently. In May 2016, Moody's reported that overall covenant quality in the market declined to 4.56 from 3.8 the previous month. The downgrade is attributed to a high amount of junk bonds being issued, ones with strict covenants that are easier to default.
Examples of Bond Covenants
On June 23, 2016, Hennepin County, Minnesota, issued a municipal bond to help finance a part of the ambulatory outpatient specialty center at the county's medical center. Fitch Ratings gave the bond a AAA rating because the bond is backed by the county's full faith, credit, and unlimited taxing power. Additionally, the rating agency gave the county's outstanding Hennepin County Regional Railroad Authority limited tax general obligation bonds an AAA rating for the same reasons, including the fact that the county can pay the debt using ad valorem taxes on all taxable property. The Hennepin County bond debenture contained a covenant stipulating that Hennepin County can levy taxes to fund the debt service at 105% annually. The debenture also stipulated that the maximum tax rate provides strong coverage of the debt service of 21.5x MADS.
As another example, 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.
The first example would be a negative covenant in that it restricts the lax levy to a maximum of 105% of the debt service. The second example is an affirmative covenant that allows for no limitations on distributions.