Bond Covenant

What Is a Bond Covenant?

A bond covenant is a legally binding term of agreement between a bond issuer and a bondholder. Bond covenants are intended to safeguard the interests of the two players.

Negative or restrictive covenants deny the issuer from undertaking certain activities; positive or affirmative covenants require the issuer to meet specific requirements.

Understanding Bond Covenants

Covenants are in many cases put in place by lenders to shield themselves from borrowers defaulting on their obligations due to financial actions hindering to themselves or the business.

All bond covenants are part of a bond's legal documentation and are part of corporate bonds and government bonds. A bond's indenture is the portion that contains the covenants, both positive and negative, and is enforceable over the whole lifetime of the bond until maturity. Conceivable bond covenants could remember limitations for the issuer's ability to assume extra debt, requirements that the issuer give inspected financial statements to bondholders, and limitations on the issuer's ability to make new capital investments.

At the point when an issuer disregards a bond covenant, it is viewed as in technical default. A common penalty for disregarding a bond covenant is the minimizing of a bond's rating, which could make it less appealing to investors and increase the issuer's borrowing costs.

For instance, 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 terrible. This means that a bond with a covenant rating of five is an indication that covenants are being disregarded reliably.

The quality of bond covenants followed by Moody's debilitated by 36 basis points to a record high of 4.47 in Q4 2020, as a resurgent market in the midst of the economic recovery permitted borrowers to refinance based on conditions significantly more friendly than what was accessible in the main half of 2020.

Affirmative Bond Covenants

An affirmative or positive covenant is a clause in a bond that requires the issuer (i.e., borrower) to perform specific actions. Instances of affirmative covenants incorporate requirements to keep up with adequate levels of insurance, requirements to outfit examined financial statements to the lender, compliance with applicable laws, and maintenance of legitimate accounting books and credit rating, if applicable.

A violation of an affirmative covenant normally brings about outright default. Certain bond issues might contain clauses that give a grace period to cure the violation. On the off chance that not rectified, creditors are qualified for declare default and demand immediate repayment of principal and any accrued interest.

Negative Bond Covenants

Negative, or restrictive, bond covenants are put in place to make issuers shun certain actions that could bring about the deterioration of their credit standing and ability to repay existing debt. The most common forms of negative covenants are financial ratios that a responsible firm must keep up with as of the date of the financial statements. For example, a clause might demand the ratio of total debt to earnings not to surpass some maximum amount, which guarantees that a company doesn't burden itself with more debt than it can bear to service.

Another common negative covenant is a 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 ensure that he generates sufficient earnings to manage the cost of paying interest.

Illustration of Bond Covenant

On June 23, 2016, Hennepin County, Minnesota, issued a bond to assist with supporting a part of the wandering short term specialty center at the district's medical center. Fitch Ratings gave the bond a AAA rating on the grounds that the bond is backed by the district's full faith, credit, and unlimited taxing power. Furthermore, the rating agency gave the district's outstanding Hennepin County Regional Railroad Authority limited tax GO bonds (HCRRA) an AAA rating for similar reasons, including the way that the province can pay the debt utilizing promotion valorem taxes on all taxable property.

The HCRRA bond debenture contained a covenant specifying that Hennepin County can levy taxes to fund the debt service at 105% every year. The debenture likewise stipulated that the maximum tax rate gives strong coverage of the debt service of 21.5x MADS.

Highlights

• Restrictive (negative) covenants rather limit a company or issuer from participating in certain actions.
• A bond covenant sets out certain activities that must be embraced, or what activities are prohibited, by a bond issuer.
• Affirmative (positive) covenants are legal vows to take part in certain activities or meet certain benchmarks added to a financial contract that an issuer must follow.
• Covenants are legally binding clauses, and in the event that penetrated will trigger compensatory or other legal action.