Covenants

Covenants Meaning

Covenant refers to the borrower’s promise to the lender, quoted on a formal debt agreement stating the former’s obligations and limitations. It is a standard clause of the bond contracts and loan agreements.

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 paymentPrincipal PaymentThe principle amount is a significant portion of the total loan amount. Aside from monthly installments, when a borrower pays a part of the principal amount, the loan's original amount is directly reduced.read more failure. It has been observed in the past that without restrictions imposed, the management of the company that issues bonds tends to operate so freely that they completely ignore bondholder’s interest and start working on an 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.

Covenants

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Source: Covenants (wallstreetmojo.com)

How do Covenants Restrictions Work?

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 bondCovenants On Their BondDebt covenants are formal agreements between different parties like creditors, suppliers, vendors, shareholders, investors, and a company, establishing limits for financial ratios such as leverage ratios, working capital ratios, and dividend payout ratios, which a debtor must refrain from breaching.read more 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

#2 – Negative

These are restrictions imposed on borrowers by lenders and are called negative covenantsNegative CovenantsA negative or restrictive covenant is a bond covenant that prohibits one party from taking certain actions, or, to put it another way, it is a pledge made by a firm to not exceed certain financial ratios unless and until the bondholders agree. Non-disclosure, non-solicitation, and non-competition are it's three types.read more 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 equityEquityEquity refers to investor’s ownership of a company representing the amount they would receive after liquidating assets and paying off the liabilities and debts. It is the difference between the assets and liabilities shown on a company's balance sheet.read more. 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 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 a 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 an 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.

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