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.
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. 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.
How do Covenants Restrictions Work?
- They are legal terms imposed on bond issuersBond IssuersBond Issuers are the entities that raise and borrow money from the people who purchase bonds (Bondholders), with the promise of paying periodic interest and repaying the principal amount when the bond matures. by lenders. Corporate need money to meet daily needs or for expansion. So they issue a bondBondBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period. 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 EBITEBITEarnings before interest and tax (EBIT) refers to the company's operating profit that is acquired after deducting all the expenses except the interest and tax expenses from the revenue. It denotes the organization's profit from business operations while excluding all taxes and costs of capital., 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 in the secured tranche, then that is a breach of covenantBreach Of CovenantBreach of Covenant occurs when the parties to a contract fail to keep the promises made in the agreement. The defaulting party who has breached the covenant may be sued for the resulting damages., 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.
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. 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 issuerBond IssuerBond Issuers are the entities that raise and borrow money from the people who purchase bonds (Bondholders), with the promise of paying periodic interest and repaying the principal amount when the bond matures..
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 two 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 statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. and to have the best corporate governanceCorporate GovernanceCorporate governance is a set of rules or practices through which an entity is directed and controlled to increase shareholders wealth by increasing the economic value and is concerned about its relations with various entity stakeholders. 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 shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares..
#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. 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.. 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.
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 RatioInterest Coverage RatioThe interest coverage ratio indicates how many times a company's current earnings before interest and taxes can be used to pay interest on its outstanding debt. It can be used to determine a company's liquidity position by evaluating how easily it can pay interest on its outstanding debt. of 3
So all the above-mentioned will have to be followed by FFC in order for them to raise $10 Million.
This has been a guide to What is Covenants and its Meaning. Here we discuss types of covenants restrictions & how does it work along with a purpose, example, and function. You can learn more about from the following articles –