Bond covenant definition
/What is a Bond Covenant?
A bond covenant is a legal agreement between the issuer and purchaser of bonds. In it, the issuer commits to avoid certain actions that might reduce its financial condition over the term of the associated bonds. The intent of this agreement is to protect the financial interests of the bond holders, thereby increasing the likelihood that they will be paid back in full as of the maturity date of the bonds. Bond covenants are fully enforceable over the term of a bond, which may span many years.
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Types of Bond Covenants
There are two types of bond covenants. One is the restrictive covenant, in which the issuer is forbidden from engaging in certain activities, such as issuing dividends to its shareholders, or taking on additional debt. Another example is the presence of a performance ratio, such as a requirement not to exceed a 1:1 debt to equity ratio. Ratio-based covenants force an issuer to maintain a conservative financial structure.
There is also the affirmative covenant, in which the issuer promises to meet certain requirements, such as paying into a bond repayment fund at certain intervals, issuing audited financial statements, and complying with all applicable laws.
When a restrictive covenant is breached by the bond issuer, it is considered a technical default. Credit rating agencies watch for these technical defaults, and will downgrade their ratings of a bond when one occurs. When a bond’s rating declines, there will likely be a sell-off on the secondary market, resulting in a decline in the bond’s price. This also means that the issuer will probably have to accept a higher interest rate if it were to issue any additional bonds to the investment community.
When an affirmative covenant is breached by the bond issuer, it is considered an outright default. In this case, bond holders can demand to be paid all principal and accrued interest at once, or following a short grace period.
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