Bond Covenant

A bond covenant is a legally binding clause in a bond's indenture that either requires the issuer to do something or prevents it from doing something during the life of the bond. Covenants exist to protect your position as a bondholder by preventing the issuer from taking actions that would increase default risk or transfer value away from debt holders toward equity holders or new creditors. The American Bar Association groups bond covenants into four main categories: restrictions on issuing new debt, restrictions on dividend payments, restrictions on mergers, and restrictions on asset disposals.

Think of bond covenants as the rules your tenant must follow in a lease: they give you legal recourse if the other party starts doing things that threaten what you were promised.

Affirmative and Negative Covenants Work in Opposite Directions

Affirmative covenants require the issuer to take specific actions. Common examples include maintaining a minimum interest coverage ratio, providing audited annual financial statements, paying all taxes on time, and keeping adequate insurance in force. These covenants confirm the issuer is running its business in the condition that justified lending it money in the first place.

Negative covenants restrict what the issuer can do. Common prohibitions include caps on additional debt issuance, limits on dividend payments if they would breach a coverage threshold, restrictions on selling core assets, and requirements to offer you a put at 101% of face value if the company changes hands. These restrictions prevent shareholders and new owners from extracting value at your expense.

Covenant Strength Reflects Negotiating Power at Issuance

During strong credit markets, issuers successfully negotiate weaker protections, sometimes called covenant-lite terms. During tighter credit conditions, bondholders recover more restrictive language. A debt-to-EBITDA cap of 3.0x is a common affirmative covenant, requiring the issuer to maintain that ratio. An asset sale covenant prohibiting transactions above a stated dollar amount without your consent is a typical negative example.

Stronger covenants lower your credit risk and, as a result, lower the yield you would demand when buying. More restrictive deals cost the issuer less to borrow. That direct tradeoff is why sophisticated issuers sometimes voluntarily accept tighter covenants when they need to reduce their borrowing cost.

A Violation Creates a Technical Default Without Missing Any Payments

Breaching a covenant constitutes a technical default even if every interest and principal payment has been made on schedule. The indenture typically provides a cure period of 30 to 60 days. If the issuer corrects the breach within that window, no further action is required. If the breach remains uncured, the trustee or a specified percentage of bondholders can accelerate the debt and demand immediate repayment of the full principal.

Sources:
https://legalclarity.org/what-are-bond-covenants-and-how-do-they-work/
https://analystprep.com/cfa-level-1-exam/fixed-income/bond-indentures-and-covenants/
https://www.superfastcpa.com/what-is-a-bond-covenant/
https://thismatter.com/money/bonds/bond-indentures.htm
https://www.referenceforbusiness.com/encyclopedia/Res-Sec/Restrictive-Covenants.html