Covenant (Definition, Example) | How Covenant Restrictions Work?

Covenants Meaning

Covenants are obligations or terms imposed on Bond Issuers by the lenders that covers legal bindings and failing which the lender may call on default and may ask the borrower to repay the bond immediately.

Explanation

The most important concern for a lender is to recover his money in full. Bond Issuers often end up taking so much debt that they end up in interest payment failure and slowly principal payment failure. It has been observed in the past that without restrictions imposed, the management of the company who issues bonds tends to operate so freely that they completely ignore bondholder’s interest and start working on expansion which eats up the cash for interest payments. So it passes the power from bond issuer to bondholder. These are legal obligations that a bondholder will have to abide by or else default will be triggered.

How does Covenants Restrictions Work?

They are legal terms imposed on bond issuers by lenders. Corporate need money to meet daily needs or for expansion. So they issue a bond to raise money and offer to pay interest on the borrowing. Lenders, on the other hand, are giving the money as they are being promised to pay interest by the borrower. So lenders will have to protect their money.
They are legal agreements between the borrower and lender that is imposed before the issuance of a bond. If the borrower agrees with the terms that the lender has imposed, then only the lender will be lending money. Ratings are provided on the bonds. There are several tranches of bonds that an organization may issue. Say an organization has issued the most secured tranche which says that their interest will be paid first from the EBIT then the rest of the tranches will be paid. So it is adding extra protection to the most secured tranche.
If somehow, the organization pays interest to lower level tranches and they fail to pay interest of the secured tranche, then that is a breach of covenant and it will trigger a default. Separate ratings are provided to specific tranches and it will lead to a down gradation of rating for the particular tranche. Once a tranche is downgraded, then it becomes expensive for the borrower to raise money as they will have to increase the interest rate to attract lenders. So they are very important and they must be fulfilled.

Function

They are legal protections imposed on the borrowers from the lenders. They work as a shield to protect the lender’s money. If the management of the organization knows that there are covenants on their bond issues, then they will act more carefully, so that they don’t breach. It forces an organization to work more efficiently and to follow proper practices to increase their income so that bondholders get paid on time. So the main function of these is to impose discipline on the bond issuer.

Types of Covenants

#1 – Positive or Affirmative

Positive covenants ask the borrower to do certain things that will be helpful in the generation of more profits or for the healthy running of the business. A lender may ask a borrower to maintain an interest coverage ratio of 2. It means the Earnings before Interest and Tax (EBIT) should be 2 times the interest that an organization needs to pay in a year.
A lender may also ask the borrower to do proper disclosure of all financial statements and to have the best corporate governance and also to appoint the best audit company for review. So these all are positive things that a borrower will have to follow if it is mentioned in covenants.
These are the best practices to be followed by any organization. So if an organization is forced to follow these then this is a blessing in disguise for the organization and its shareholders.

#2 – Negative

These are restrictions imposed on borrowers by lenders and are called negative covenants because they cut the normal flow of operations of the borrowers. It may impose restrictions like the borrower can’t take a further loan or they can’t issue further equity. So these kinds of restrictions though safeguards the money of lender but they create problem in the normal operation of the organization

Purpose of Covenant

They are imposed to protect the lender if the management of the borrower’s organization starts acting against the bondholders. Bond Holders take the help of covenants to impose restrictions on the borrower, so borrowers are now forced to think for the interest of the lender. The main concern of bondholders is the default from the borrowers, so all the covenants are restrictions imposed on the borrower by the lender to safeguard the lender’s wealth.

Covenants Example

FFC Ltd is planning to issue bonds worth $10 Million. FFC approached a few lenders and offered to pay interest of 8%. The lender after proper evaluation of the creditworthiness of FFC decided to put few covenants before buying the bonds.

FFC can’t issue any other bonds of the same seniority after this issue
FFC can’t issue equity
FFC will have to maintain Interest Coverage Ratio of 3

So all the above-mentioned will have to be followed by FFC in order for them to raise $10 Million.

Conclusion

These are very important for lenders to protect their wealth. Positive acts as a booster to maximize profit for the organization. So it is a good way to impose discipline in an organization, but too many covenants will make the organization lose on opportunities that would result in erosion of profit.