Bond Covenants

A covenant is a pledge or undertaking by an issuer to do certain things or avoid others. Usually, a covenant will be a "financial covenant" which specifies that, for example, the issuer will maintain an interest coverage ratio over a certain level or a leverage ratio (debt/equity) under a specific level. These ratios are meant to constrain the issuer to financial prudence. Covenants can also be "non-financial" in nature, such as providing financial information to bondholders, protecting against the selling of assets, or changes of control, or making sure the assets of the company have adequate insurance.

Issuers do not like to have covenants because they restrict their actions. This is why the majority of recent bond issues do not have covenants. Issuers with outstanding "covenant" bond issues have "closed off" these issues and currently issue debt under their unsecured debenture and mid-term note programs. This is one of the reasons for the development of "asset-backed securities". They enable bond investors to obtain specific assets as security and protective features in bond issues. Instead of investing in an unsecured mid-term note of an auto-finance company, an investor could invest in "auto-loan" receivables through an asset-backed trust originated and serviced by the same company.

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