Debt Covenants

What are Debt Covenants?

Debt covenants are formal agreements or promises that are made between different parties like creditors, suppliers, vendors, shareholders, investors, etc and a company that states the limits for financial ratios such as leverage ratios, working capital ratios, dividend payout ratios, etc which a debtor must refrain from breaching.

Ideally, when the lenders lend the money to the borrowers, they sign an agreement. And under this agreement, the borrowers have to maintain certain restrictions so that the interest of the lenders is protected.

Debt Covenants

Source: akelius.com

Debt covenants (Bond Covenants) can be called by many names. Two of the popular names are banking covenantsCovenantsCovenant 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.read more and financial covenants. Actually, they all mean the same thing.

Why are debt covenants necessary?

In other words, why bond covenants lenders would restrict the borrowers from doing something? The bond covenant lenders don’t want to pressurize the borrowers with rules and restrictions. However, if they don’t bind the borrowers with few terms & conditions, they may not get their money back.

It is also important to note that debt covenants also help the borrowers (yes, even after being restricted). When the agreement between the borrowers and the lenders is signed, the terms & conditions are discussed. And if the borrowers abide by the terms, they may need to pay a lower interest rate (cost of the borrowing) to the lenders.

Debt Covenants

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Source: Debt Covenants (wallstreetmojo.com)

Debt Covenants Example

Let’s say that Icebreaker Co. has taken debt from a bank. The bank has offered the company a $1 million loan stating that until the company pays off the bank the principal plus a 10% interest, the company won’t be able to take any additional loan from the market.

The restriction imposed by the bank on Icebreaker Co. would be called a bond covenant. But why the bank would do such a thing? Let’s analyze it.

  • First of all, the bank would do its own due diligence before lending the amount to the Icebreaker Co.
  • If the bank finds that Icebreaker Co. doesn’t have a good risk-profile, lending a big amount would be risky too for the bank. In this case, if the company goes out and also borrows a million here and another million there and goes belly up, the bank will not get back its money.
  • Thinking about the future risk, the bank may restrict the company from borrowing any additional loan until the loan of the bank is being paid off in full.

Bond Covenants Metrics

How do the lenders get to know what bond covenants they need to impose upon the borrower? Here are some metrics that the lenders/borrowers need to look at before imposing bond covenants.

Positive Debt Covenants

Positive debt covenants are things that the borrowers must do to ensure that they get the loan. Below is a Positive bond Covenant example.

Positive Covenants

source: marineharvest.com

Other positive debt covenants example

Negative Debt Covenants

Negative debt covenants are the things the borrowers can’t do. Below is a negative bond covenant example.

Negative Debt Covenants

source: marineharvest.com

Other negative debt covenant examples

Video on Debt Covenants

 

This has been a guide to what are debt covenants. here we discuss the positive and negative bond covenants along with its metrics like total assets, debt to assets, debt to EBITDA, debt to equity, interest coverage ratio, and dividend payout ratios. You may also go to other articles on Corporate Finance –